How does analysts' forecast quality relate to corporate investment efficiency?
Introduction
The capital investment decisions are one of the most fundamental and important factors that determine the value of the firm and therefore investors' wealth. Key determinants for a firm to make efficient investment decisions include knowledgeable and dedicated management teams and sufficient availability of capital. Prior literature shows that high quality financial reporting and corporate governance mechanisms can help prevent or mitigate firm's suboptimal investments by disciplining managers' behaviors and reducing the cost of capital. However, there is a lack of investigation into the effects of external financial analysts, which are one of the most important external monitoring agents of company managers. In our study, we attempt to fill this gap in the literature by examining how the quality of the earnings forecasts made by financial analysts impact firms' investment efficiency.
In an ideal world without any frictions, firms invest efficiently by undertaking investment projects with positive net present values (Modigliani and Miller, 1958). However, in reality, managers make over- or under-investments when their private interests deviate from those of shareholders. Financial constraints due to higher returns required by external capital providers who lack information can cause under-investment (Myers, 1984). Alternatively, the “lemons problem” of managers selling overpriced securities gives rise to over-investment (Baker et al., 2003). Prior literature shows that the quality and characteristics of financial reporting disclosed by firms are associated with higher investment efficiency (Biddle et al., 2009, Cheng et al., 2013, Lara et al., 2016). Richardson (2006) finds that the over-investment of free cash flows can be mitigated by certain governance structures such as the presence of activist shareholders and the adoption of anti-takeover provisions. These studies focus on how the firms' disclosures and internal governance mechanisms can help reduce over- and under-investment, but they do not directly examine the effects of one of the most important external monitoring agents and information intermediaries, namely, financial analysts.
Different views regarding the roles played by financial analysts have been widely discussed since the seminal paper of Jensen and Meckling (1976). Recent literature has reached a consensus that financial analysts have influences on firm value as well as the behavior of managers in such matters as earnings management, cash holding decisions, CEO compensations, tax planning activities, and others. We extend this literature by examining whether external analysts can influence a firm's investment decisions. In particular, we argue that the quality of analysts' earnings forecasts, measured by the dispersion and accuracy of the forecast earnings per share, could affect investment efficiency through three channels.
First, by serving as information intermediaries between firms and outsiders, financial analysts can help capital providers and investors gain more insights about the firms' future prospects and real investment decisions, and this process inhibits managers from undertaking value-destroying activities (e.g., Bowen et al., 2008, Kelly and Ljungqvist, 2012), which is referred to as “information intermediary role” of financial analysts. Second, the process of researching firms and making earnings forecasts involves interfacing with management directly (e.g., communications with the managers and company visits), which allows financial analysts to directly monitor the firms and influence decision making (e.g., Yu, 2008, Chen et al., 2015). When the analysts' earnings forecasts are more accurate and have less dispersion, such monitoring effects on firms tend to be stronger. This is referred to as “monitoring agent role” of financial analysts. Third, financial analysts could create excessive pressure on managers by setting external performance benchmarks (i.e., earnings forecasts) that firm managers usually accept as targets to achieve (e.g., He and Tian, 2013, Allen et al., 2016, Irani and Oesch, 2016). The short-term pressure on managers imposed by financial analysts is expected to exacerbate managerial myopia and impair firms' incentives to invest, which is referred to as “market pressure role” of financial analysts. The first two views predict a positive association between forecast quality and investment efficiency, whereas the third pressure view predicts a negative relationship between forecast quality and investment efficiency.⁎†
We test the relationship between forecast quality and investment efficiency using a panel dataset of U.S. publicly listed firms spanning a long sample period from 1983 to 2011. To measure the quality of analyst forecasts, we use the standard deviation of earnings forecasts multiplied by minus one, denoted by Dispersion, and the absolute difference between the forecast consensus and actual earnings multiplied by minus one, denoted by Accuracy. We follow Biddle et al. (2009) and Cheng et al. (2013) in estimating a firm's likelihood of over-investing or under-investing based on the firm's cash and leverage levels. Our study focuses on the relation between the quality of analyst earnings forecasts and investment levels conditional on a given firm's likelihood of over-investing or under-investing.
Our analyses show that, on average, a one-decile higher Dispersion (or Accuracy) increases the investment of financially constrained firms by 3.77% (or 2.65%) and decreases the investment of financially abundant firms by 3.01% (or 2.12%). The results suggest that the quality of analyst earnings forecasts, measured by Dispersion and Accuracy, is associated with lower over-investment and lower under-investment, which supports the predictions of information intermediary role and monitoring agent role but does not support the market pressure role of analyst forecasts. Our regression models explicitly control for the effects of other corporate governance mechanisms that have been documented or hypothesized to be associated with investment efficiency, including the quality of financial reporting, institutional stock ownership, analyst coverage, and the E-index of Bebchuk et al. (2009), an anti-takeover defense measure. Our study confirms the findings reported by Biddle et al. (2009) and Cheng et al. (2013) that the quality of financial reporting, considered as a proxy of information asymmetry, is associated with higher investment efficiency. However, as Dispersion and Accuracy remain highly significant in reducing over- and under-investments, our findings on analyst forecast quality go beyond the information channel provided by financial reporting.
In sub-sample analyses, we find that the effects of analyst forecast quality on over-investing and under-investing firms are stronger for those that have a higher deviation from the expected investment level, higher information asymmetry, and lower institutional stock ownerships. These results that the effect of analyst forecast quality on investment efficiency are more pronounced for firms with poor information environment and/or weaker governance from other external monitoring mechanisms are consistent with the information role and monitoring role of financial analysts, respectively.
The Dispersion and Accuracy of analyst earnings forecasts and firms' investment efficiency could be simultaneously determined by some omitted firm-specific variables. To handle this potential endogeneity problem, we use Dispersion and Accuracy lagged by two years as instrumental variables and estimate standard two-stage-least-square regressions. We also identify settings where firms are more likely to either over- or under-invest using the ranked variables aggregated at the industry level. Finally, we employ a small sample of firms experiencing an exogenous decrease in analyst coverage. None of these tests nor a battery of other robustness tests alters our conclusions.
Our study contributes to the growing body of literature on the determinants of firm-level investment efficiency (e.g., McNichols and Stubben, 2008, Biddle et al., 2009, Jian and Lee, 2011, Goodman et al., 2013, Cheng et al., 2013, Lara et al., 2016, Chen et al., 2017). While the prior literature focuses on how the quality or properties of financial reporting and internal management decisions influence firm-level investment efficiency, our study examines the effects of one of the most important external monitoring mechanisms and information intermediaries, namely, external financial analysts. Our results show that the analyst activity matters for investment efficiency even after controlling for a firm's disclosure quality as well as other governance mechanisms. Therefore, we add to the literature by showing the incremental impact of the information produced and governance performed by financial analysts on investment efficiency.
Second, our study contributes to the literature that investigates the information and monitoring roles played by financial analysts in corporate activities. Financial analysts monitor firms through releasing private and public information to investors and directly interfacing with firms' managements (e.g., Jensen and Meckling, 1976, Chen et al., 2015). A key issue for financial analysts when making earnings forecasts is to evaluate whether the investment decisions made by the firms are efficient, given the availability of capital and investment opportunities. While prior research has controlled for coverage or presence of financial analysts as a possible governance mechanism to explain investment efficiency,‡ our study focuses on the quality of earnings forecasts made by financial analysts and finds consistent and significantly positive effects across different model specifications and estimation methodologies.
The paper proceeds as follows. Section 2 reviews the relevant literature and develops our hypotheses. Section 3 describes the data sample, measurements of variables, and research methodologies. Section 4 presents our main regression results on the quality of analyst earnings forecasts and how they impact firms' investment efficiency, including the results of sub-sample analyses. Section 5 discusses robustness tests and Section 6 concludes.
Section snippets
Management incentives, availability of capital, and investment efficiency
In a frictionless market, firms are expected to invest efficiently by undertaking projects with positive net present values (Modigliani and Miller, 1958), while it has been long recognized that firms make suboptimal investment decisions in reality and either over- or under-invest. Reasons for inefficient investments can be attributed to the conflict of interests between managers and shareholders (Jensen and Meckling, 1976) and the financial constraints faced by firms (Myers and Majluf, 1984).
Data sources
We obtain data on earnings forecasts made by financial analysts and the actual earnings of firms, respectively, from the Unadjusted Detail History file and Unadjusted Detail Actuals file of the Institutional Brokers Earnings Systems (I/B/E/S).††
Empirical results
This section presents the regression results of our main analysis and investigates whether the quality of analyst earnings forecasts, captured by Dispersion and Accuracy, are associated with firms' over- and under-investment. We also conduct further explorations on the relations by examining the circumstances under which the influence of Dispersion and Accuracy is more pronounced, using sub-sample analysis.
The endogeneity problem and robustness checks
In this section, we redo the regression analyses considering the potential endogeneity problems, which are followed by sub-period regressions, other robustness checks, and an additional analysis about the effects of Accuracy and Dispersion on firms' future performance.
Conclusions
Our study investigates whether the quality of the earnings forecasts made by financial analysts provides information about the efficiency of firms' investment decisions. Prior studies suggest different channels through which analyst forecasts affect investment. According to the information intermediary, monitoring agent, and investor recognition arguments, high forecast quality increases investment efficiency, whereas market pressure argument predicts a negative effect of forecast quality on
Acknowledgements
The authors gratefully acknowledge Professor Michael Firth for his great contribution to the earlier versions of this paper, the comments and suggestions of an anonymous reviewer, and conference participants at the 2016 American Accounting Association Annual Meeting. The authors also thank Lin Chen, Wayne Yu, Jin Gao, Sonia Wong, and seminar participants at Lingnan University and the Hong Kong Institute of Business Studies for helpful comments on earlier versions of the paper.
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