Market earnings expectation, measurement error in analysts’ consensus forecasts and prediction of stock returns

Abstract

Purpose

In capital markets research, analysts’ consensus forecasts are widely used as a proxy for unobservable market earnings expectation. However, they measure the market earnings expectation with error that may vary cross-sectionally, as the market does not consistently rely on analysts’ consensus forecasts to form earnings expectation (Walther, 1997). Based on this notion, this paper aims to relate the prediction of future stock returns to the cross-sectional variation of the error in measuring market earnings expectation embedded in analysts’ consensus forecasts.

Design/methodology/approach

This study uses empirical analyses based on stock returns and annual analysts’ consensus forecasts.

Findings

Based on the analytical work by Abarbanell et al. (1995), this study reports that when the measurement error in annual analysts’ consensus forecasts is the smallest, forward earnings-to-price ratio (constructed with annual analysts’ consensus forecasts) best explains future stock returns, and the forward earnings-to-price ratio-based investment strategy is the most profitable.

Originality/value

Findings of this study are useful to capital markets research that relies on the market earnings expectation and to practitioners seeking more profitable investment strategies.

Citation

Kim, J.H. (2018), "Market earnings expectation, measurement error in analysts’ consensus forecasts and prediction of stock returns", Accounting Research Journal, Vol. 31 No. 2, pp. 249-266. https://doi.org/10.1108/ARJ-03-2016-0031