Study: Wall Street analysts routinely inflate stock prices

Wall Street analysts often provide biased research in response to investment banking pressures, according to a new study by a Business School researcher.

"Sell-side analysts have long faced allegations that pressures to generate investment banking business compromise the soundness of their investment research," says Richard Sloan, professor of accounting and finance. "Our evidence supports these allegations. We found that analysts routinely hype the stock of firms raising new financing so that these firms can issue securities at temporarily inflated prices."

Sloan and two of his former doctoral students, Mark Bradshaw of Harvard Business School and Scott Richardson of the Wharton School at the University of Pennsylvania, examined data from financial statements and stock returns from 1975-2000 for more than 100,000 firm-year observations.

They found that the degree of overoptimism in sell-side analysts' earnings forecasts, stock recommendations and target prices is systematically related to corporate financing activities–especially for firms issuing new securities.

"The economic significance of our results is striking," Sloan says. "For example, we find that target prices set by analysts are, on average, 80 percent too high for firms issuing securities versus only 20 percent too high for firms repurchasing securities."

The researchers say that the predictability of future stock returns–which historically have been unusually low in the three years following securities issuances and unusually high during the same time-frame for securities repurchases–is due to temporary mispricing rather than risk.

"The predictable future stock returns are directly related to predictable biases in analysts' earnings forecasts," Sloan says. "It appears that investors initially buy into analysts' biased earnings expectations and are subsequently surprised by the predictable forecast errors.

"Further, we find that analysts set significantly higher future target prices for firms issuing securities than for firms repurchasing securities. If the lower future stock returns for issuing firms represent a lower risk premium, then we would expect analysts to set lower target prices for such firms."

The study also shows that analysts tailor their overoptimism to the type of security being issued. For example, analysts typically exaggerate short-term earnings prospects of debt issuers to reduce the perceived credit risk of these securities. In contrast, they overstate the long-term growth potential of equity issuers in order to sell securities at higher prices.

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