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Empirical Economics

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13-09-2022

Does corporate governance affect financial analysts’ stock recommendations, target prices accuracy and earnings forecast characteristics? An empirical investigation of US companies

Authors: Ahmed Bouteska, Mehdi Mili

Published in: Empirical Economics | Issue 4/2022

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Abstract

This paper investigates how corporate governance quality affects the analyst’s stock recommendations, forecast efficiency and target price accuracy on New York Stock Exchange. In particular, as corporate governance is often uncertain and ambiguous to investors, expert financial advisors may use transparent corporate governance information to set their recommendations and improve the level of accuracy of their earnings forecasts. According to agency and signaling theories, good governance mechanisms aim to mitigate agency conflicts and boost corporate transparency. Thus, we argue that they can serve as mediators during the forecasting process and we expect a strong significant relationship between the effectiveness of corporate governance mechanisms and analyst activity. Five hypotheses are tested with a large sample of 154 US market firms over a 17-year period (2004–2020). Our empirical findings point out some special features of US stock markets. We find evidence that analysts tend to issue favorable recommendations, more accurate, less dispersed and more optimistic earnings forecasts for most well-governed firms. Furthermore, we show that higher-quality governance transparency is an important determinant of financial analysts’ behavior in the USA. The results also indicate that higher-quality governance appears valuable with financial analysts during pre- and post-crisis period, while it is not generally detected in COVID-19 times. However, we report the weakness of analysts’ outputs–governance quality for small firms. Thus, our findings cast doubts over the corporate governance-based analyst practices of US small and unaffiliated firms. The main implication of these findings is to improve understanding of how investors’ behavioral characteristics affect the transmission mechanism of information in money market and capital market prices. This paper has important implications for the decision making of financial analysts and investors by requesting firms to significantly improve their information environments in the good and bad times. It also offers insights into how firms establishing good corporate governance mechanisms can help the analysts to predict future stock prices.

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The date December 1, 2019, corresponds to the date when (COVID-19) spread in Hubei Province and then spread to 212 countries where the United States and European Union alongside Iran are the most affected.

The authors consider other distinct measures that seize target price accuracy. They use Metend, which is a dummy variable that is equal to one if the stock price at the end of the 6-month forecast horizon is equal to the target price and zero otherwise and Metin which is a dummy variable that is equal to one if the target price is met during the 6-month forecast horizon and zero otherwise. Both measures are less demanding since their purpose is limited to target price achievement (below or above), but do not assess the magnitude of error. In our current study, we do not use those measures because they always take the value of zero.

Clement (1999) suggests that the forecasting experience and the number of followed firms which is a proxy of portfolio complexity to be among analyst determinants. He argues that well experienced analysts and who follow few industries are more likely to issue accurate forecasts.

Kerl (2011) affirms that stock price volatility is positively associated with target price accuracy. He also explains his finding by the fact that compared to low volatile stocks, higher volatile stocks are more likely to achieve the target price during or at the end of the forecast horizon.

Following Abdul Wahab et al. (2015)’s reasoning about that updating corporate governance mechanisms with each change in operating environment is not an easy matter and naturally takes time. In addition, Larcker et al. (2007) prove the difficulty of setting an optimal corporate structure and maintaining it at all times. In the lightof this argument, simultaneous bias may be left away. Hence, we aim to control for omitted variable bias since we are aware of the absence of other relevant variable e.g. audit quality and audit independence.

See Terza (2017) and Basu et al. (2018).

Outliers for the TPE variable are detected and because they can mislead our results, we remove TPE observations that are greater than 95th percentile and below 5th percentile. Note that we started with 99th and 1th percentile and each time we eliminate 1th percentile in both sides until the deletion of all extreme observations.

We are using bootstrapping analysis method allowing random sampling to alleviate the small number of observations.

Marginal effects for the financial and non-financial sample.

We don’t report empirical results to conserve place. However, they are available under request.

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Title: Does corporate governance affect financial analysts’ stock recommendations, target prices accuracy and earnings forecast characteristics? An empirical investigation of US companies
Authors: Ahmed Bouteska
Mehdi Mili
Publication date: 13-09-2022
Publisher: Springer Berlin Heidelberg
Published in: Empirical Economics / Issue 4/2022
Print ISSN: 0377-7332
Electronic ISSN: 1435-8921
DOI: https://doi.org/10.1007/s00181-022-02297-3

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