by Dr Yuan Li, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance
Financial analysts are important information intermediaries in the capital markets because they engage in private information search, perform prospective analyses aimed at forecasting firms’ future earnings and cash flows, and conduct retrospective analyses that interpret past events (Beaver, 1998). The information produced by analysts is disseminated to capital market participants via analysts’ research outputs, which mainly include earnings forecasts and stock recommendations. Prior academic studies suggest that the main role of an analyst is to supply private information that is useful to parties such as investors and managers. Therefore, an analyst’s ability to produce relevant private information that is not already known to other parties is an important determinant of the analyst’s value to the capital markets. Based on this notion, CCFin research associate Yuan Li and her co-authors propose a simple and effective measure of analyst ability.
Their measure of analyst ability is calculated as one minus the correlation coefficient between the analyst’s forecast revisions and prior stock price changes within successive forecasts. Since prior stock price changes capture the incorporation of information that is already known to investors, any information in an analyst’s forecast revisions that is not correlated with prior stock price changes reflects the analyst’s private information. In other words, their measure captures the ability of an analyst to produce information that is not already incorporated into stock prices.
Their research finds that the stock price impact of forecast revisions issued by superior analysts identified by our measure is greater. They also find that firms covered by more superior analysts are less likely to engage in earnings management. These findings suggest that superior analysts identified by their measure are better information producers and monitors.