Why Does Analysts’ Forecast Dispersion Predict Stock Returns? A Corporate Guidance Perspective

Recent studies find that stocks with higher dispersion of analysts’ earnings forecasts have lower future returns. The phenomenon is popularly interpreted as evidence that stock prices reflect optimism in the presence of differences of opinions and short-sales constraints. This paper shows that there is also a negative relationship between forecast dispersion and a firm’s unexpected future earnings. We provide an alternative explanation consistent with empirical patterns in both earnings performance and stock market reaction. In our model, analyst forecast dispersion is endogenously determined by corporate earnings guidance strategies; further, firms with better earnings prospects provide more accurate earnings guidance, leading to less dispersed analysts forecasts. Further empirical analysis supports this explanation. ∗Mark Liu is from Department of Finance, Boston College. Danielle Xu and Tong Yao are from Department of Finance, University of Arizona. Corresponding author: Tong Yao, Department of Finance, University of Arizona, Tucson, AZ 85721. Email: [email protected]. We thank Ashiq Ali, Kathy Kahle, Hong Yan, and seminar participants at University of Arizona for helpful comments. Data on analysts forecasts is provided by I/B/E/S. Errors are our own. Why Does Analysts’ Forecast Dispersion Predict Stock Returns? A Corporate Guidance Perspective