An Empirical Analysis of Analysts' Target Prices: Short Term Informativeness and Long Term Dynamics

Alon Brav, Duke University Reuven Lehavy, University of California at Berkeley First Version: December 2000 Current Version: May 2001

Abstract
Using a large database of analysts' target prices, we examine short-term market reactions to target price announcements and long-term co-movement of target and stock prices. We find a significant market reaction to the information contained in analysts' target prices, both unconditional and conditional on contemporaneously issued stock recommendations and earnings forecast revisions. For example, the spread in average announcement day abnormal returns between positive and negative target price revisions is as high as 7 percent. We also find that stock recommendations and earnings forecast revisions are informative controlling for the information in target prices. Using a cointegration approach, we explore the long-term behavior of market and target prices and estimate the system's long-term equilibrium. In this equilibrium a typical firm's one-year ahead target price is 22 percent higher than its current market price. Finally, while market prices react to the information conveyed in analysts' reports, we show that any subsequent corrections towards the long-term equilibrium are, in effect, done by analysts alone. We provide evidence that the market understands the latter relationship and is therefore able to anticipate, at least partially, analysts' target price revisions.

We are grateful to Jeff Abarbanell, Ravi Bansal, Tim Bollerslev, David Hsieh, Jack Hughes, Roni Michaely, and seminar participants at University of Illinois-Champaign, University of North Carolina at Chapel Hill, University of Toronto, and Purdue University for their comments, and thank Mark Carhart for providing the factor time-series. We also thank the following individuals for their insights: Stan Levine from First Call, Jennifer Lyons from Lend Lease Rosen Real Estate Securities LLC, Jim Wicklund from Dain Rauscher Inc, Ralph Goldsticker from Mellon Capital Management, Len Yaffe from Bank of America Securities, and Peter Algert from Barclays Global Investors. We owe special thanks to John Graham, Campbell Harvey, and Richard Willis for many invaluable insights and comments. All remaining errors are ours. Please address correspondence to either Brav at Fuqua School of Business, Duke University, Box 90120, Durham, North Carolina 27708, phone: (919) 660-2908, email: brav@mail.duke.edu or Lehavy at University of California, Berkeley, Haas School of Business, Berkeley, California 94720, phone: (510) 642-5372, email: Lehavy@haas.berkeley.edu.

An Empirical Analysis of Analysts' Target Prices: Short Term Informativeness and Long Term Dynamics
Security analysts provide investors with forecasts of earnings, stock recommendations, and target prices. These outputs convey their opinion about a firm's expected earnings performance and price changes. Academics and practitioners alike have been interested in understanding the value and usefulness of these signals to investors. This interest has resulted in a wide body of academic research and numerous articles in the business press documenting that investors react to the information contained in analysts earnings forecasts and stock recommendations. Surprisingly, however, the properties of analysts' target prices, which presumably provide the most concise and explicit statement on the magnitude of the firm's expected return, have remained unexplored. While some anecdotal evidence related to announcements of price targets is provided by the business press, academic research on what is arguably analysts' most informative statement on firms value target prices is essentially non-existent.1 Using a large database of analysts target prices, we attempt to fill this void by investigating two questions. We begin by examining the short-term informativeness of target prices. Given that target prices provide investors with analysts most explicit quantitative statement regarding firms expected return (or relative mispricing), we expect announcements of target prices to be associated with a significant market reaction. Consistent with this prediction, we document significant abnormal returns around target price revisions and show that the abnormal returns are increasing in the favorableness of the target price revision. We also examine the incremental informativeness of target prices conditional on contemporaneously

Bradshaw [2000] reviews a sample of 103 analysts' reports and finds that the most frequently cited explanations given in support of a recommendation and target price are price to earnings ratios and forecasted long-term earnings growth rates. For a subsample of 67 firms, he documents a significant correlation between target prices, stock recommendations, and earnings based measures. Using a sample of 300 Canadian firms Bandyopadhyay, Brown and Richardson [1995] find that forecasted earnings explain a large proportion of the variation in price forecasts. OBrien [2001] reflects on the controversy regarding the value of price targets: price targets, at their worst, can be used to exploit unsophisticated investorsNow that some of the dust has settled, market professionals are seeing some marginal value in price targets, if only in interpreting the vernacular of Wall Street. Vickers and Weiss [2000] describe that analysts are increasingly lobbing absurdly extreme calls that attract big-media attention and encourage momentum investing.

issued stock recommendations and earnings forecast revisions and find evidence that target price revisions are incrementally informative even in the presence of the other two signals. Our second question is motivated by the fact that target prices are forward looking and, much like stock prices, linked to the underlying firm fundamental value. Therefore, using a cointegration framework, we examine the long-term dynamics that link target and market prices. In particular, the ratio of target price to the underlying stock price provides a natural measure of analysts estimate of the firms annual expected return. The cointegration analysis allows us to estimate the mean of this ratio, which we interpret as the long-term equilibrium of the two price series, and to quantify the speed and magnitude of adjustments of the two series towards this long-term relationship. The analysis reveals that target prices are, on average, 22 percent higher than concurrent market prices, and that this ratio is inversely related to firm size. We also find that once the system of prices has been shocked away from its long-run equilibrium, it is analysts who revise their targets back to the equilibrium relationship. Market prices, in contrast, barely contribute to this correction phase. These long-term dynamics raise the possibility that target price revisions are partially predictable. We test for this possibility and we find evidence that investors are able to anticipate, at least partially, analysts' target price revisions. The paper proceeds as follows. Section I reviews related literature and describes our predictions. Section II describes the data. We examine the information content of target prices in section III. Section IV describes our cointegration approach to modeling the long-term comovement of target and stock prices. Section V presents the cointegration results. Some of the insights from the cointegration analysis are then used in section VI to argue that target price revisions are partly predictable. A summary and conclusion is offered in Section VII.

I. Related Research and Empirical Predictions

Our examination of the informativeness of analysts' target prices contributes to extant research on the information content of analysts' two other signals: stock recommendations and

earnings forecasts. This research generally finds significant positive (negative) price reaction to recommendation upgrades (downgrades) (e.g., Elton, Gruber, and Grossman [1986], Stickel [1995] and Womack [1996]) and that the level of consensus analyst stock recommendations predicts future gross abnormal returns (e.g., Barber, Lehavy, McNichols, and Trueman [2001]). Recommendations have also been shown to contain information that is generally orthogonal to the information in other variables known to have predictive power for stock returns (Krische and Lee [2000]). Francis and Soffer [1997] focus on the relative informativeness of analysts' earning forecast revisions and stock recommendations and find that each signal is informative in the presence of the other, while Stickel [1999], Bradshaw [2000], and Markov [2001] examine the consistency between consensus recommendations and consensus earnings forecast revisions. We add to this research by examining the properties of analysts' target prices. We begin our analysis with an examination of market reaction to target price announcements. Because target prices provide investors with the analysts most explicit quantitative statement regarding firms' expected returns, we expect to observe significant average market reaction around announcement of such price targets. Furthermore, since greater upward (downward) revisions in target prices are likely to represent more (less) favorable news, we expect market reactions around target price revisions to increase in the favorableness of the revision. Target prices, however, are issued in conjunction with stock recommendations and earnings forecasts. We therefore extend our analysis to determine whether target price are incrementally informative. Given the discreteness of stock recommendations we expect target prices to be informative even in the presence of stock recommendations. Since earnings

forecasts are but one input into the target price calculation, we expect target prices to convey information to market participants above and beyond that in the earnings revision. While it is reasonable to expect target prices to be informative relative to stock recommendations and earnings forecasts, the reverse is not obvious. If the target price is an output of a valuation model that reflects the analyst's beliefs in the fundamental value of the firm, mapping such a target price into a stock recommendation is informationally redundant. Investors
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can immediately infer the recommendation by comparing the target price to the current stock price. Similarly, if earnings forecasts, along with other factors such as discount rates and payout ratios, are inputs to the analyst valuation model, then the information in the earnings forecasts is already reflected in the target price. This view suggests that both recommendations and earnings forecast revisions should be uninformative in the presence of target price revisions. There are, however, several reasons to expect stock recommendations and earnings forecast revisions to be informative in the presence of target prices. First, for a given target price, stock price movements that increase the magnitude of mispricing but, in the analyst opinion, do not necessitate a target price revision, might lead the analyst to keep his target price but revise his recommendation. For example, a 10 percent decrease in the price of a stock currently rated a Buy might increase the stocks attractiveness, which can be easily conveyed to investors by an upgrade from Buy to Strong Buy even without a target price revision. Second, for a given ratio of target to market price, analysts argue that recommendation revisions provide additional information on the level of confidence in that target price. For example, a target price which exceeds current stock price by 20 percent could be perceived as more credible if it is accompanied by a Strong Buy rather than a Buy recommendation. Put differently, a target price might reflect the mean of the analysts posterior beliefs regarding the firm value, while a recommendation provides additional information regarding the dispersion of these beliefs.2 Finally, earnings forecast revisions might also prove informative in the presence of target prices. This can occur if investors consider earnings forecasts as informative but disagree with the way the analyst incorporated the earnings information into his pricing model. We test empirically these competing views on the information role of stock recommendations and earnings forecasts in the presence of target prices.

Another potential explanation, provided to us by a Goldman Sachs analyst, is that target prices convey a precise measure of firm mispricing relative to current market price, while a recommendation may provide additional mispricing information regarding a cross-section of similar stocks. For example, if certain investors are constrained to hold a certain subset of the market, such as a given industry, then an analyst can employ recommendations as a measure of intra-industry mispricing.

The second objective of this paper is to examine the long-term comovement of stock and target prices. Since both of these variables are linked to the underlying firm fundamental value we model them as a cointegrated system. As we discuss in more detail below, target prices are forward-looking, usually, one year ahead. Therefore, the ratio of the target price to the underlying stock price provides a measure of analysts beliefs regarding the firms annual expected return. The cointegration framework allows us to estimate the mean of this ratio and to ask whether its magnitude is consistent with the predictions of some commonly used assetpricing models. We also analyze the price systems reaction to deviations from its long-term equilibrium ratio and quantify the speed and magnitude of adjustment of the two series towards this longterm relationship. Our goal is to examine which price series corrects to the long-term

equilibrium once the price system has been shocked away from it. Are analysts' reacting to deviations from the long-term equilibrium by adjusting their target prices or are market participants responsible for most of the long-term adjustments? Under the null of market efficiency, we predict that market prices react to the information conveyed in an analyst's report but that any subsequent corrections to the long-term equilibrium are done by analysts alone.3

II.
A. Data Description

Data and Variable Descriptions

The target price, stock recommendation, and earnings forecast data employed in this paper are provided by First Call. First Call has been a major supplier of analyst data to both practitioners and academics. While the First Call data spans a shorter period than that of some of their competitors (e.g., Zacks or I/B/E/S), First Call has always maintained that its data collection procedures place great importance on ensuring accuracy, especially with respect to the timing of
A related question is whether the (ex-ante) returns forecasted by analysts are unbiased and whether these forecasted returns are more accurate relative to forecasts generated from asset pricing models such as the CAPM or intrinsic value measures such as in Lee, Myers, and Swaminathan [1999]. Since our goal is to first understand the dynamics that link the two price series, we examine these questions in a follow-up paper (Brav, Lehavy, and Michaely [2001]).
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the reports. To that end, a distinguishing feature of the First Call database is that it codes the source of each analysts report as either Real-time or Batch. Real-time refers to reports received from live feeds such as the broker notes and are dated as the date that the report was published. Batch reports are generated from a weekly batch file from the brokers and the precise publication dates of the reports are unknown. With technological improvements in First Call's data collection procedures, by 1999, the overwhelming majority of reports are coded as Real-time. To ensure accurate dating of analysts' reports, our empirical analyses include only observations coded as Real-time. Table I provides descriptive statistics for the First Calls target price database (panel A), stock recommendation database (panel B), and earnings forecast revision database (Panel C). These statistics are provided for firms with available data on the Center for Research in Security Prices ("CRSP"). The year 1997 is the first one with a complete target price data (coverage begins in November 1996 with 3,862 target price reports for that year). Coverage increases over time substantially from about 50,000 price target reports in 1997 to about 94,000 reports in 1999. The average number of price targets per covered firm (column 3) also increases from 10 in 1997 to 18 in 1999. The target price database is quite comprehensive and includes reports for 6,544 distinct firms.4 The number of participating brokers remained fairly constant over the years, with an increase from 123 in 1997 to 149 in 1999 (column 5), with 190 distinct brokers issuing price target reports across all years. Each firm in the sample is covered, on average, by six brokers. Finally, we find that these firms account for approximately 93 percent of the total market value of all securities on CRSP and that many of the large brokers are represented in the database and also account for a significant proportion of the observations. Panel B of Table I provides a description of the recommendation database. In 1997, the database includes 32,295 recommendations for 5,572 distinct firms. By 1999, the number of recommendations reaches 42,014 for 5,929 distinct firms. The number of brokers remains fairly
4

We have verified with an official at First Call that in those cases in which analysts report target price range estimates, First Call records these as mid-point estimates.

constant over the years with overall 325 distinct brokers included in the database. Consistent with claims made by several analysts that certain brokerage houses which issue recommendations have either a formal or an informal policy barring issuance of price targets, the number of brokers issuing recommendations is higher than those issuing price targets.5 Panel C of Table I provides a description of the earnings forecast revision database. The database includes about 124,000 earnings forecast for the period from 1997 to 1999. These forecasts are distributed, on average, as seven forecasts per firm and pertain to 9,167 distinct firms. These forecast revisions are issued by 282 distinct brokers with an average of seven brokers per covered firm. B. Variable Descriptions We construct three alternative measures for the information content of analysts target prices. The first, denoted TP/P, is the ratio of the announced target price to the stock price outstanding two days prior to the announcement (all prices are converted to the same splitadjusted basis). This ratio can be interpreted as the analysts estimate of the firms expected return. The second measure attempts to capture whether investors react to information in target price relative to the brokerage houses prior target price. This measure, denoted TP/P, is the difference between the current and prior target price issued by the same brokerage house, deflated by stock price outstanding two days prior to the announcement. The third variable is designed to capture investor reaction to information in target price relative to the outstanding consensus target price. Consensus target price is calculated as the average target price across all brokerage houses. Target price outstanding for more than 90 days are excluded from the consensus. This measure, denoted (TP-ConsTP)/P, is the difference between the brokerage houses target price and the outstanding consensus target price immediately prior to the
In unreported results we find that the majority of stock recommendations are issued as either Buy or Strong Buy (68 percent), while only 29 percent are issued as a Hold and 3 percent as a Sell or Strong Sell. Also, the median number of days between revisions is 59 days for target prices, 141 days for stock recommendations, and 92 days for earnings forecasts. Additional description of the recommendation and target price databases is available in Appendix A.
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announcement. This ratio is deflated by the firm's stock price two days prior to the announcement.6 Panel A of Table II presents statistics on the three information measures as well as on the earnings forecast revision. We winsorize these variables at the 1st and 99th percentiles to mitigate the possible effect of extreme observations. These statistics indicate that the distributions of all three measures are right skewed. Relative to pre-announcement stock price, target prices are higher by 32.9 percent, are 17.5 percent higher than the brokerage houses' previously issued target price, and 11.5 percent higher than the outstanding consensus target price.7 The right-most column in Panel A presents descriptive statistics on the earnings forecast revision measured as the change in the analyst forecast of earnings for the current fiscal year deflated by stock price two days prior to the announcement. The mean (median) forecast revision is -0.41 (-0.03) percent. Panels B through D of Table II list the averages of the three target price information measures conditional on the associated recommendation change. In general, changes in the target price measures are consistent with the direction of the recommendation changes. For example, Panel B reports that upgrades are generally associated with higher TP/P ratios than downgrades. In Panels C and D we also find that the mean TP/P and (TP-ConsTP)/P are consistently positive for upgrades and negative for downgrades. For example, an upgrade from a Buy to a Strong Buy recommendation is associated with a mean upward revision in TP/P of 26.7 percent whereas a downgrade from Buy to a Hold recommendation is associated with a mean downward revision of 10.2 percent. Similarly, an upgrade from a Hold to a Strong Buy recommendation is associated with a mean revision in target price relative to consensus target price of 20 percent while a
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We have also explored a further refinement of the three information measures by scaling each of these measures by the prior price standard deviation measured over the 90 days preceding the event. We find qualitatively similar results in Section III with these scaled information measures. 7 In unreported results we find that, consistent with the common wisdom that analysts prefer dropping rather than downgrading stocks with unfavorable prospects (e.g., McNichols and O'Brien [1997]), the frequency of target price downgrades is fairly small. Only about 5 percent of target price reports are issued below concurrent stock price, about 25 percent of target price reports reflect downward revision from brokerage houses prior report, and about 43 percent reflect a downward revision from the outstanding consensus target price.

downgrade from a Strong Buy to a Hold recommendation entails a revision of 9.9 percent in the target price. Finally, consistent with the notion that recommendation reiterations contain less information than recommendation upgrades or downgrades, such reiterations are associated with relatively smaller target price revisions. We have also calculated statistics, as in Panels B through D, for the variation in earnings revisions by stock recommendation revisions (unreported). Similar to the results in these panels, we find that earnings revisions are monotonically related to the favorableness of the recommendation change. The fact that revisions in target prices, recommendations, and earnings forecasts are generally in the same direction suggests that, at least partially, these signals share the same information content. In Section III we explore whether the information in each of these signals subsumes the information in the other.

III.
A.

Market Reaction to Target Price Announcements

Unconditional Informativeness of Target Prices In this section we examine whether the information content of target prices announcements

is associated with abnormal returns around those announcements. Specifically, we compute the abnormal return around each announcement and present the average abnormal return for portfolios ranked on the basis of the magnitude of the relevant information content measure. Abnormal return is computed as the difference between the firm buy and hold return and the buy and hold return on the NYSE/AMEX/NASDAQ value weight market index over the period beginning two days prior to and ending two days subsequent to the target price announcement.8 These results are reported in Figure I and Table III. The visual evidence in Figure I and the reported results in Table III indicate that average abnormal return around target price revisions is statistically significant and, in general,
Results for the period of 1 to +1 days around the announcement are qualitatively similar. Also, to avoid possible cross-correlation problem due to identical return observations, we delete all but one of identical return observations within each portfolio.
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monotonically increasing in the favorableness of the revision. For example, the average abnormal return for portfolios ranked on the basis of the change in the target price relative to the outstanding consensus target price, (TP-ConsTP)/P, range from an average of 2.164 percent for the least favorable revision to 2.608 percent for the most favorable one. The largest spread in abnormal returns is in portfolios ranked on the basis of the change in the individual brokerage house target price with average returns ranging from 3.956 percent to 3.208 percent for the least and most favorable revisions, respectively.9 Combining these findings with those in extant literature of a significant positive (negative) price reaction to favorable (unfavorable) stock recommendation (e.g., Womack [1996] and Stickel [1995]) and earnings forecast revisions (Givoly and Lakonishok [1979], Elton, Gruber, and Gultekin [1981], Lys and Sohn [1990], and Francis and Soffer [1997]) raises an interesting question regarding the incremental information content of target prices in the presence of these two other signals. We therefore extend our analysis, in Section III.B below, to distinguish whether target price revisions are incrementally informative.

B.

Informativeness of Target Prices Conditional on Stock Recommendations and Earnings Forecast Revisions Table IV provides regression results relating event-day abnormal returns to

recommendation levels, recommendation changes, earnings forecast revisions, and the target price revision measure TP/P.10

In unreported results we performed three additional robustness tests. In the first we examined whether earnings announcements drive the documented average returns around target price announcements. To this end we excluded from the abnormal return calculation observations that fell within a five-day window of an earnings announcement. The results are qualitatively the same. Second, to account for the possibility that the documented abnormal return is due to other firm specific events immediately prior to the target price announcement, we calculated abnormal returns starting at day zero through day +2. Our results remain unchanged. Finally, we extended the post-event window through sixty days after the target price announcement. We found no abnormal return for positive revisions and some evidence of negative drift (-4 percent) for negative target price revisions. We leave for future research a detailed examination of the predictive ability of target prices. 10 This information proxy is the scaled change in the individual brokerage house target price. We present results using this proxy to ensure comparability with the earnings forecast and recommendation revisions that are also based on the individual brokerage house's revision. Analysis using the other two measures yields similar results.

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We begin, in panel A, by regressing event-day abnormal returns, AR, on three recommendation levels, the earnings forecast revision, F/P, and the target prices revision TP/P.11 Our goal is to determine whether target price revisions are informative in the presence of earnings revisions and the level of the stock recommendation. In particular, we the regression takes the following form:
F TP AR = 1HOLD + 2 BUY + 3 SB + + + P P

where the indicator variables take the value 1 if the stated recommendation level is met and zero otherwise. The regression results clearly indicate that target price revisions are positively and significantly related to event-day abnormal returns controlling for the information in the level of the associated stock recommendation and the earnings forecast revision (=4.312 with t statistic=46.5). Economically, a one standard deviation in TP/P contributes to a 0.424*4.312=1.83 percent average event day abnormal return. Moreover, the estimates of the coefficients 1, 2, and 3 and their ordering ( 1 < 2 < 3 ) provide evidence that the level of the stock recommendation is informative in the presence of target price revisions. Indeed, we can easily reject the joint hypothesis that these parameters are equal with an F test (pvalue=0.000). Finally, the positive and significant coefficient on F/P indicates that the

information in the earnings forecasts revisions is not completely subsumed by the target prices revisions or the stock recommendations. In panel B we extend our tests and examine whether target prices are incrementally informative controlling for recommendation and earnings forecasts revisions. Our regression takes the following form:
F TP AR = 1UPGRADES + 2 DOWNGRADES + 3 REITERATIONS + + + P P

11

We exclude from the analysis Sell or Strong Sell recommendations due to the small number of observations.

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where the indicator variables take the value 1if the stated recommendation revision is met and zero otherwise. Much like the results in the previous panel, we find that target price revisions are incrementally informative. The estimated coefficient is significant both statistically and economically. We also find that both revisions in earnings forecasts and stock recommendations are informative as well. The coefficients 1, 2, and 3 and their expected ordering ( 1 < 2 < 3 ) provide evidence that these revisions are incrementally informative. For example, recommendation upgrades (downgrades) contribute an additional 2.486 (3.495) percent to the average event-day return. We can easily reject the joint hypothesis that these parameters are equal with an F test (p-value=0.000). We note that, consistent with prior research (e.g., Barber at el [2001], Francis and Soffer [1997] and Stickel [1995]), investors appear to place a greater weight on recommendation downgrades than on recommendation upgrades. This finding is consistent with the view that since analysts are more likely to issue recommendation upgrades than recommendation downgrades, such downgrades are perceived by the market as more informative.12 The final set of tests is provided in panel C. Unlike the setup in the previous panel we now expand the set of indicator variables to include specific recommendation revisions. Having established that target prices are incrementally informative we now examine whether the degree of the revision in the stock recommendation (e.g. Hold to Strong Buy relative to Hold to Buy) is incrementally informative controlling for the target price and earnings forecast revision. As we proposed in Section I, the degree of the stock recommendation revision might be employed by analysts to signal their posterior uncertainty in the overall assessment of the firms valuation. We implement our regression setup as follows:

It is interesting to note the role that target prices and earnings forecast revisions play in the case of recommendation reiterations that have been shown to be the least informative (e.g. Barber et al. [2001]). Given the economically small intercept associated with recommendation reiterations (-0.114), it can be seen that in such reiterations investors appear to place virtually all weight on the information conveyed by the target prices and the earnings forecast revisions.

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AR = 1 HOLDtoSB + 2 BUYtoSB + 3 HOLDtoBUY + 4 SBtoHOLD + 5 SBtoBUY + 6 BUYtoHOLD F TP + 7 SBtoSB + 8 BUYtoBUY + 9 HOLDtoHOLD + + + P P

where the indicator variables take the value 1 if the stated recommendation revision is met and zero otherwise. To ensure a meaningful interpretation of the incremental role of the relative recommendation revision, we focus on recommendations that were either revised from or revised to the same recommendation. The relevant comparison are (i) upgrades to Strong Buy from either Buy or Hold (i.e., a test of 1=2), (ii) upgrades from Hold to either Strong Buy or Buy (i.e., a test of 1=3), (iii) downgrades from Strong Buy to either Hold or Buy (i.e., a test of 4=5), and (iv) downgrades to Hold from either Strong Buy or Buy (i.e., a test of 4=6).13 The regression results are consistent with the prediction that larger revisions in stock recommendations are more informative. For example, the coefficient estimate associated with upgrades to Strong Buy from Hold (3.276) is significantly different (p-value of 0.024) from the one associated with upgrades to Strong Buy from Buy (2.246). Similarly, the coefficient

estimate associated with downgrades from Strong Buy to Hold (-4.485) is significantly different (p-value of 0.008) from the one associated with downgrades from Strong Buy to Buy (-3.109). Results are somewhat weaker for revisions either from or to Hold. For example, the p-value

Because First Call converts the specific language of the recommendation into Strong Buy, Buy, Hold, Sell or Strong Sell, some of the information contained in the recommendations is lost. For example, while a recommendation of Market Performer, Natural, Maintain or Hold may convey a different message to investors, all these recommendations are all being coded as Hold on the First Call database. In terms of our empirical analysis, this lowers our ability to find results in support of our prediction.

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associated with the test of difference in the coefficient of downgrades from Strong Buy to Hold relative to a revision form a Buy to Hold is 0.056.14 In sum, the evidence in Tables III and IV indicates that target prices are informative controlling for the information in stock recommendations and earnings forecast revisions. Furthermore, we document a role for the degree of the recommendation change which is consistent with the prediction that analysts use the degree of the recommendation revision as a signal of their confidence in their target price (e.g., variability in posterior beliefs).

IV.

Modeling Long Term Equilibrium between Market Prices and Target Prices

The analysis in Section III suggests that market participants perceive analysts' target prices as an informative signal regarding firm value. That analysis, however, cannot address the second issue discussed above, regarding the joint movement of stock and target prices. Since both of these price series are linked to the underlying firm fundamental value, we study the dynamics of their long-term co-movement. Because both sets of prices are nonstationary, we employ a cointegration framework and estimate the linear combination of the price series that is stationary. This linear combination is termed as the system's long-term equilibrium and is parameterized as the ratio of target and market prices. Cointegration also implies that any price deviations from this long-term equilibrium ratio are stationary as well. That is, if on a given date the system is in equilibrium, a shock to any of the variables will lead to a price path that will

In additional (untabulated) tests, we allow the slope coefficient on the target price and earnings forecast revisions to differ across recommendation levels (strong buy, buy, and hold) and changes (upgrades, downgrades, and reiterations). Specifically, we estimated three separate regressions of event-day abnormal return on an intercept, TP/P, and F/P by the level of the recommendation (i.e., Strong Buy, Buy, and Hold), and three similar regressions by the change in the recommendation (upgrades, downgrades, and reiterations). We then test for the equality of the three respective slope coefficients for each set of regressions. The null hypothesis of equality of the coefficient estimates on the target price revision is rejected for both the set of the Strong Buy, Buy, and Hold regressions and the upgrades, downgrades, and reiterations regressions. The coefficients on target price revisions are inversely related to the favorableness of the recommendation. Consistent with the prediction in Francis and Soffer [1997], we find that the coefficient on earning forecast revision is increasing in the favorableness of the recommendation.

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settle back to the long-term equilibrium.15 We analyze the price systems reaction to deviations from this long-term equilibrium ratio by examining which price series corrects to the long-term equilibrium once the system has been shocked away. That is, are analysts the ones reacting to deviation from the long-term equilibrium by adjusting their target prices or are market participants responsible for most of the adjustment? Moreover, how long is required for the system to converge back to its long-term equilibrium? Our empirical analysis is conducted on time series of individual firms weekly consensus stock and target prices. Consensus target price is calculated as the average target price across all brokerage houses. Target price outstanding for more than 90 days were excluded from the consensus. We choose a weekly interval to avoid microstructure problems associated with daily data. Given the long-term nature of the cointegration analysis, we require each firm to have a minimum of 500 trading days (approximately 104 consecutive weeks) with continuous stock and target price data. The final sample consists of 900 firms. While the choice of a two-year minimum reduces the number of firms that we can study, it is a necessary requirement as we are interested in studying the long-term dynamics of target and market prices.16 To set the stage for our methodological approach and to build intuition for the full sample analysis, we begin by examining the joint price behavior of a single firm, IBM. We present the full-scale analysis in Section V.

15

We follow the cointegration literature (Engle and Granger [1987]) by using the term equilibrium in reference to the relation that ties together the two price series over the long-run. The main motivation for the use of this term is the idea that when two cointegrated economic variables drift apart then economic forces (market mechanism, for example) tend to drive them back together. Lee, Myers, and Swaminathan [1999] employ this intuition in modeling the long-term relation between price and intrinsic value on the Dow 30 stocks. As Campbell and Shiller [1988] have argued, however, such an "equilibrium" can occur simply because one variable is a rational expectation of the future of another variable which follows an integrated process. Campbell and Shiller's interpretation is important since target prices are, by definition, analysts' forecasts of future prices. 16 We have replicated the cointegration analysis using a minimum of 250 trading days and obtained similar results. In addition, the analysis was also conducted on size-sorted portfolios containing all firms in our database. Again, our conclusions regarding the dynamics of market and target prices remain unchanged.

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A.

Basic Setup and Application to IBM's price Behavior Figure II depicts the time-series of weekly market prices for IBM over our sample period,

January 1997 through December 1999, taken from CRSP. We also plot the weekly consensus target price and the ratio of target prices to market prices, denoted TP/P. Inspection of this figure provides a key insight. While both price series are non-stationary,17 it is evident that market and target prices share a long-run common relationship. This association is captured by our third variable, TP/P. It can be seen that target prices, which are forward looking, are consistently higher than current market prices but the ratio of the two price series fluctuates about a common value at approximately 1.2 (see the right-hand-side vertical axis). When either price series deviates from this ratio, the system tends to revert back to it over time. Using a cointegration approach (Engle and Granger [1987]) we provide direct evidence regarding both the long-term relationship and the manner with which these prices correct towards this long-term equilibrium. To do that, we assume that annual expected return, and therefore the mean of the TP/P ratio, is constant over our sample period.18 We estimate both the magnitude of this ratio and the dynamics that force the two sets of prices to converge to the longrun equilibrium. We have already established that the market reacts to the information conveyed in the analyst's report. Any remaining departure from the long-term relationship should therefore be eliminated by analysts and/or market participants revising their prices. Our goal is to quantify these price dynamics. Since we want to retain the flexibility of modeling different beliefs regarding the association between market and target prices and allow for parameter uncertainty, we adopt a Bayesian approach to cointegration (see Bauwens and Lubrano [1996] and Bauwens and Giot [1997]). Within the Bayesian framework, we begin with subjective prior beliefs regarding the model parameters. Posterior beliefs are then generated using sample information via Bayes theorem. These beliefs summarize our knowledge about the parameters of interest conditional on
17 18

We are unable to reject the null of non-stationarity with an augmented Dickey-Fuller test. Over 90 percent of the price target reports used to construct the consensus estimate are one-year ahead prices.

16

both the model and the data. An important feature of the Bayesian framework is that it enables us to formally incorporate subjective prior beliefs regarding the parameters of interest. For example, prior beliefs which indicate that IBM is risky (in a CAPM sense, for example) should lead to a higher expected return and therefore to prior beliefs that the mean of the TP/P ratio is high. Alternatively, prior beliefs that indicate that the firm is overvalued should lead to a lower expected return and therefore that the mean of the TP/P ratio is low. Finally, Bayesian posterior beliefs explicitly reflect our uncertainty about the firms parameters known as estimation risk (e.g., Barry (1974), Jorion (1991), and Klein and Bawa (1976)). We now describe the methodology as applied to IBM. We denote the time t target price by tpt and market prices pt. Let xt denote a (2 x 1) vector with elements tpt and pt. Both variables are assumed integrated of order one, that is, stationary after first differencing. Cointegration of the two price series means that there is a (2 x 1) vector such that the linear relationship 'xt=0. For example, if, on average, analysts forecast that target prices are twenty percent higher than current market prices then = [ 1 1.2] . We begin by writing the price system in an error correction form:

xt = i xt i + xt 1 + t , t = 1,K, T ,
i =1

(1)

where xt i is a (2 x 1) vector of first differences lagged i periods and t ~ N (0, ) , assumed independent over time. The matrices i and are both (2 x 2) and the latter is assumed positive definite. is the (2 x 2) long-run impact matrix which contains the cointegrating vector. Inclusion of this term in this Vector Autoregressive Regression ("VAR") follows from the Granger Representation Theorem. 's rank is equal to the number of cointegrating relationship which in our simple case is just one. Following earlier literature we parameterize as follows:

= ' ,

(2)

where both and are (2 x 1) vectors. contains the cointegrating coefficients and is the vector of weights in the VAR regression. The vector can be interpreted as a vector of

17

"adjustment coefficients", that is, the elements in allow us to quantify how target prices and market prices react to past dis-equilibrium errors. By obtaining posterior beliefs on the elements in we can quantify the way in which the two time-series contribute to the correction of the system back to the long-term equilibrium. Given this parameterization, Equation (1) can be re-written as follows, ~ Y = X + Z '+ E = X + Z '+ E = WB + E ,

(3)

(T x k) matrix in which the rows are simply (xt' 1 ,K, xt' p +1 ) so k = 2 ( p 1) . In the empirical

where Y is a (T x 2) matrix containing the time t first differences of the two vectors, xt . X is a

implementation below we set p=3 as we find no qualitative differences in the results for longer lags. Z is a (T x 2) matrix with the tth row x ' t 1 . E is a (T x 2) matrix of stacked residuals t' . is a (k x 2) matrix obtained by stacking the i' matrices. The parameter matrix B = ' is a ~ ~ ~ ((k+1) x 2) matrix. W = X Z is a (T x (k+1)) matrix, and Z = Z can be interpreted as

( )

( )

'

capturing the time-series of deviations from the long-run equilibrium. The likelihood function is therefore,

l ( , B , )

T / 2

~ ' ~ exp 0.5 tr 1 Y WB Y WB

)(

)}

(4)

We specify a diffuse prior on all the model parameters accept for . As Bauwens and Lubrano [1996] point out, an informative prior on and the added identification of the first element in = ( 1, b ) , guarantee that the marginal posterior for the cointegrating coefficient will have finite moments. The latter informative prior is denoted p0 (b ) and we assume it is a Normal distribution with mean b and standard deviation b . Setting b equal to 1.2 means that the investor believes that the one-year-ahead target price should be twenty percent higher than current market price. Obviously, the strength of such beliefs is governed by the magnitude of b with highly informative beliefs captured by small values for b . Section IV.B below provides the detailed construction of p0 (b ) . Prior beliefs are therefore given by
p0 (b, B, )
n+1 2

p0 (b ) .

(5)

18

The joint posterior distribution is proportional to the product of the prior distribution in equation (5) and the likelihood in equation (4). Our main goal is to obtain the marginal posterior distributions of our parameters of interest, and b, as well as any functions of these parameters. These marginal distributions are derived in Appendix C.

B.

Specification of Prior Beliefs The specification of prior beliefs in equation (5) necessitates a construction of the prior

distribution p0 ( ) . As described above, the identification of the first element in , = ( 1, b ) , implies that we need to form the prior on b, which captures analysts' beliefs regarding the firm's expected annual return. For example, setting the mean of these beliefs equal to 1.2 indicates that we believe that IBM's annual return is expected to be twenty percent. Recall that our price data begins in January 1997. Hence, our efforts in generating the investor's prior beliefs necessarily center on the period preceding this month. In particular, we use the five-year period form January 1992 through the end of 1996 to form the posterior beliefs of a Bayesian investor regarding IBM's expected annual return. These beliefs serve as prior beliefs for the cointegration analysis. The formation of investor beliefs requires that we take a stand on an asset-pricing model and then derive the investor's posterior beliefs conditional on the chosen model. We assume that asset returns are generated by the Fama-French [1993] three-factor model. The first factor is the excess return on the value weighted market portfolio (RMRF). The second factor is the return of a factor-mimicking portfolio, SMB, which is the return on a zero investment portfolio formed by subtracting the return on a large firm portfolio from the return on a small firm portfolio. Similarly, the third factor is the return of another mimicking portfolio, HML,

19

defined as the return on a portfolio of high book-to-market stocks less the return on a portfolio of low book-to-market stocks.19

ribm, t rf ,t = 0 + 1 RMRFt + 2 SMBt + 3 HMLt + t

'

(6)

Let [ 0 , 1 , 2 , 3 ] denote the (4x1) vector including the intercept and factor loadings and a (3x1) vector of factor premiums. Given this asset-pricing model, we write IBM's monthly expected excess return, , as follows,

= 1 '

[ ]

(7)

We derive 's posterior moments following Pastor and Stambaugh [1999]. Their approach is adopted for two reasons. First, it is fully Bayesian and therefore allows us to account for uncertainty in both the factor loadings, , and factor premiums, . Second, Pastor and

Stambaugh's approach provides an elegant way with which we can allow for model mispricing. That is, we can incorporate a belief in the falsehood of the asset-pricing model and allow for analyst's beliefs in the mispricing of the firm's equity. For example, prior beliefs that IBM's expected return is higher by one percent per month relative to the model's prediction are easily captured by centering prior beliefs on 0 accordingly. Appendix B provides the detailed construction of beliefs regarding IBM's monthly expected excess return, , which are then used to derive beliefs for the firm's annual expected return. The latter beliefs, which we capture by a Normal distribution, serve as prior beliefs for the cointegration analysis below. We present the cointegration results in Section C below and highlight the sensitivity of our conclusions to differing prior beliefs.

The breakpoints for small and large are determined by NYSE firms alone, but the portfolios contain all firms traded on NYSE, AMEX, and NASDAQ. The breakpoints for the high book-to-market portfolio represents the top 30 percent of all firms on COMPUSTAT while the low book-to-market portfolio contains firms in the lowest 30 percent of the COMPUSTAT universe of firms. We have also replicated the analysis in this section using both the CAPM and a four-factor model as in Carhart [1997]. The conclusions drawn in this section are robust to these alternative assetpricing models.

19

20

C.

Cointegration Results for IBM We present the cointegration results in Table V. We focus our attention on posterior

moments for b, the parameter capturing the long-run ratio of target prices relative to market prices, and the vector of response coefficients , the 2x1 vector capturing the response coefficients of each price variable to deviations from the long-run equilibrium. The table contains two panels that reflect the investor's prior beliefs in model mispricing (see the discussion in Section IV.B and derivation in the Appendix). Panel A corresponds to prior beliefs that ignore any mispricing and impose dogmatic beliefs in the exact pricing ability of the threefactor model. Panel B allows for mispricing. We do so by setting 0 , the parameter governing the standard deviation of prior mispricing, to one percent and center the prior mean of mispricing, b , at zero. The message from both panels is similar. Beginning with Panel A, posterior beliefs regarding b, the long-run ratio of target prices to market prices, are centered at 1.204 with standard deviation equal to 1.7 percent. Panel B, in which we allow for mispricing, results in posterior beliefs regarding the long-run ratio that are centered at 1.215. While prior beliefs were centered at 1.117 and 1.177, the differences in prior beliefs regarding mispricing have a relatively minor effect on b's posterior distribution. This is a direct result of the fact that the prior's standard deviations in both panels are high and relatively uninformative relative to the large sample information. The posterior moments of the vector of response coefficients , in either panel, provide interesting evidence on the manner with which target and market prices adjust to the long-term equilibrium. The target price response, tp, is large and positive with a relatively low posterior standard deviation while the market price response, market, is close to zero with relatively high posterior uncertainty. This means that once the system of prices has been shocked away from its long-term equilibrium, it is analysts, rather than market participants, who tend to revise their target prices towards the long-run equilibrium. For example, a one-dollar shock in either target or stock price that causes the system to deviate from its long-run equilibrium ratio of 1.204, will
21

be corrected by analysts adjusting target prices downward by 21.9 cents each week while market prices adjust by a negligible 3.3 cents. Combining IBMs cointegration results with the event analysis above provides preliminary evidence that market prices, in effect, only respond to the information conveyed in the announcement of target prices, but otherwise do not react to temporary deviations from the long-term relationship with target prices.

V. Full Sample Implementation of the Cointegration Analysis

In this section we implement the cointegration analysis for the full sample of 900 firms and derive, for each firm, posterior beliefs regarding the parameters of interest. These

parameters capture the long-run ratio of target prices relative to market prices, b, and the 2x1 vector of response coefficients, , that captures how each price variable responds to deviations from the long-run equilibrium. Unless noted otherwise, we begin by estimating these parameters using prior beliefs which impose dogmatic beliefs in the Fama and French three-factor model. Since the regression analysis results in 900 posterior distributions, we report statistics on the means and standard deviations of these posterior distributions. We report the results in Table VI. Panel A contains information regarding posterior means for the parameters of interest b and , while Panel B provides information regarding posterior standard deviations for the same parameters. In each panel we report full sample results in the first row. In the next five rows we report the same statistics for sub-samples of firms sorted by market capitalization ("size").20 To the extent that size differences are associated with cross-sectional differences in information asymmetry or risk, our analysis sheds light on the dynamics of target prices as they relate to this firm characteristic. We discuss results related to the posterior distributions of the long-run ratio of target to market prices, b, in Section V.A. The

Size quintiles are formed on the basis of NYSE capitalization cutoffs and are adjusted quarterly. Each Amex and NASDAQ firm is placed in the appropriate NYSE size quintile based on the market value of its equity at the end of the quarter.

20

22

discussion regarding the posterior distributions of the vector of response coefficients is given in Section V.B.

A.

Posterior Beliefs Regarding the Long-Run Ratio of Target to Market Prices, b. Consider first the full sample results given in the first row of Panel A. The fifth and sixth

columns indicated that the grand-average of the 900 posterior means equals 1.22 with a 0.07 standard deviation. That is, conditional on at least two years of continuous consensus coverage, we find that the average firm in this sample is expected to earn 22 percent annually.21 Note that the third and fourth columns present, for comparison purposes, the grand average of the prior means which equal 1.15 with a standard deviation of 0.04. It can be seen that if analysts form their beliefs using data preceding our sample period, then there is, on average, 22-15=7 percent discrepancy in the expected annual return. Further information regarding the parameter b is given in first row of Panel B. Across the 900 firms, the grand-average of the posterior standard deviations is 3.5 percent and the standard deviation of this second moment is 1.8 percent. These figures tell us that the average firm bs posterior distribution is centered at 22 percent with a standard deviation equal to 3.5 percent. Last, as in Panel A, the third and fourth columns present, for comparison purposes, the grand average of the prior standard deviations, which equal 5.8 percent with a standard deviation 1.5 percent. The remaining rows in both panels of Table VI provide results for firms sorted into size quintiles. Beginning with firms in the smallest quintile, the grand-average of b's posterior means is 1.27 and it declines monotonically to 1.19 for the firms in the largest quintile. From Panel B we can see that posterior standard deviations also decline monotonically from 5.4 percent to 2.6 percent as we move from the smallest to the largest quintile. This pattern indicates that,

21

The geometric average annual market return over our sample period is 19.9 percent.

23

conditional on being followed, analysts expect a higher annual price appreciation for small stocks. As can be seen from the third column, which provides the prior means, part of the crosssectional difference in analysts' expected annual return is indeed driven by differences in threefactor risk exposures. Risk, however, cannot explain all of these differences. First, it can be seen that the three-factor model generates 18-13=5 percent spread in expected annual returns between the large and small stocks whereas the sample spread is 8 percent. Furthermore, as we noted earlier, the asset pricing models that we entertain here generates prior beliefs that are lower by an average of 7 percent across the size quintiles. The preceding evidence on the discrepancies between b's prior and posterior means can be explained in two ways. First, analysts might employ an asset-pricing model which predicts systematically higher expected returns than the three-factor model. To explore this possibility, we replicate our analysis with other asset pricing models such as the CAPM and Carhart's (1997) four-factor model which also controls for differences in average returns due to momentum effects. We find, however, similar results. Next, we examine whether allowing for mispricing uncertainty about the Fama and French three-factor model, as in Pastor and Stambaugh [1999], can explain the above discrepancy. To this end, we repeat the estimation with prior beliefs which allow for possible mispricing (prior mean of regression's intercept set to zero while the prior standard deviation is set to five percent (see Section IV.B). We find that over the prior formation period, the posterior means of the intercepts are positive for two-thirds of our sample firms suggesting that b's prior beliefs are likely to be higher now. Indeed, when we compute, for each size quintile, the average of b's prior means, we find that there is near uniformity between the latter prior and posterior averages. We conclude that employing the three-factor model while allowing for mispricing provides a potential explanation for the above discrepancy. The second explanation for the above pattern rests on an alternative interpretation of the parameter b. We have assumed so far that b, the long-run ratio of target prices relative to market prices, provides an estimate of the unconditional annual expected return. An alternative view,
24

however, is that it is an estimate of the conditional expected return, where the conditioning is on favorable news.22 This hypothesis suggests that rather than using the full prior distribution for b, analysts, in effect, calculate conditional expected returns based on a truncated prior distribution of annual return. Entertaining a more favorable realization of a future state of nature leads to a higher truncation, and therefore to a higher implied conditional mean. We examine this hypothesis by calculating, for each firm, the truncation percentile of the prior distribution that leads to equality of b's conditional prior and posterior means. For example, Table V shows that, for IBM, when mispricing is ruled out, the prior p0 (b ) is a normal distribution with mean b = 11.7%, standard deviation b = 4.9%. The first panel in the same table shows that b's posterior distribution is centered at 20.4%. Given these parameters, it is easily verified, using the moments of a truncated Normal distribution, that one would have to truncate the mass below the 93rd percentile in order for the conditional mean of the truncated prior to equal 20.4%. When we repeat this calculation for all the firms in our sample we find a large variation in these imputed percentiles. Specifically, while the mean (median) truncation percentiles are 48 (49), these imputed percentiles are evenly spaced over the 1- 99 percent range. One possible interpretation of these results is that, on average, analysts issue target prices which condition on a firm annual return exceeding its expected return as dictated by the three-factor model. The large dispersion that we find in these truncation percentiles, however, leads us to conclude that it is unlikely that the conditioning hypothesis provides a complete explanation. Since a large number of the imputed percentiles, including IBM's, are larger then 90 percent, it seems more plausible that for some firms analysts condition both on favorable news and rely on an asset pricing approach that allows for mispricing in determining target prices.

William Epifanio, a J.P. Morgan analyst commented on a price target he had set on Red Hat in February 2000 The price target on the stock was contingent on a variety of things happening that did not happen. (Cassell BryanLow [2000]).

22

25

B.

Posterior Beliefs Regarding the Response Coefficients, tp and market. We begin with the full sample results given in the first row of Panel A of Table VI. The

seventh and eighth columns provide the grand-average of tps posterior means. It is equal to 8.9 percent with a 4.3 percent standard deviation. These statistics imply that, for the average firm, the analyst's periodic (i.e., weekly) response to a one-dollar deviation from the long-term equilibrium is to revise the target price by 8.9 cents. As discussed earlier, a positive response coefficient is consistent with analysts revising their target prices towards the long-term equilibrium once the system has been shocked away. In contrast, the market price response coefficient, market, is small and close to zero, as can be seen from column nine. Panel B provides information regarding the response coefficients posterior standard deviations. Consider tp first. The grand-average of the 900 posterior standard deviations is 2.5 percent which indicates that, for the typical firm, the analysts response coefficient posterior distribution is centered at 8.9 percent with a 2.5 percent standard deviation. This evidence fits nicely with the observation that virtually all of the posterior mass for this parameter is over the positive range and is consistent with our interpretation of the results that analysts revise their targets towards the long-term equilibrium. In contrast, the same statistics for market indicate that across the 900 posterior distributions, a typical firms posterior distribution is centered at 1.5 percent with a large posterior standard deviation of 3.7 percent. Unlike analysts response coefficient, the latter posterior distribution is centered close to zero indicating that there is little posterior evidence that market prices react to deviations from long-term equilibrium. The posterior information about the response coefficients tp and market indicates that there are no cross-sectional differences in analysts' and market reaction to deviations from the long-term relationship across the size quintile sorts. As with the IBM results in Section IV, the evidence supports the interpretation that market prices react to the information conveyed in an analyst's report but that any correction to the equilibrium relationship between target and market prices is, in effect, done by analysts alone. Given this result, we explore in Section VI the possibility that analysts' target price revisions are predictable and revisit some of the event-study

26

results presented earlier in Section III.23

VI.

Are Target Price Revisions Predictable?

The evidence presented in the preceding sections indicates that target price revisions are associated with a significant market reaction and that subsequent corrections to the long-term equilibrium relation between target prices and market price is, in effect, done by analysts alone. Taken together, these findings raise the possibility that revisions in analysts target price are, to a certain extent, predictable. For example, suppose that in response to a target price revision (or change in stock price) the ratio of target to market price now deviates from its long-term equilibrium. Then, it is more likely that the direction of a subsequent target price revision will be back toward the long-term relation, rather than away from it. Indeed, market participants should be able to predict the analysts revision towards the long-term equilibrium the further are current target prices from market prices. Put differently, if the likelihood that a target price revision towards the long-term relationship is increasing in the magnitude of the deviation from the longterm equilibrium relation, then market reactions to target price revisions should be inversely related to the extent of the pre-revision deviation. We test this prediction by examining stock price reactions to target price revisions conditional on: (i) the distance between the current ratio of the target to stock price and the long23

We have also attempted to quantify the average length of time within which the system of market and target prices reverts to its long-term equilibrium by computing the price system's impulse response function (Lutkepohl and Reimers [1992], Hamilton [1994], Koop [1996], Lee, Myers, and Swaminathan [1999]). Computation of an impulse response function requires that we inject into the system a shock with respect to one of the variables and then examine the path of both prices over time. Such a shock, say to target prices, is usually a one standard deviation shock which is also orthogonalized with respect to the remaining variable, namely market prices. We obtain draws from a firm's half-life posterior distribution as follows. First, recall that the derivation of posterior beliefs, described in Appendix B, results in our having 1,000 simulated draws from each of the model parameters' posterior distributions. Second, conditioning on each such draw we calculate a corresponding half-life and therefore obtain the whole posterior distribution for the firm's half-life. A complication, however, which is common to both the Bayesian and frequentist approaches, is that stationarity of the process is not imposed during the estimation. In our setting this sometimes results in non-convergence of one realization of a half-life (out of a 1,000) and therefore inability to report finite moments for the posterior distribution. While it is beyond the scope of this paper to impose finite moments on these posterior beliefs we calculate, for each firm, only one half-life realization by using the posterior means of each of the regression parameters. In this manner, 99 percent of the resulting half-lives are finite. For these firms we find that both mean and median half-lives are equal to 10 weeks. We do not find any cross-sectional differences in half-lives when we sort the sample firms by size.

27

term value of this ratio and (ii) the direction of the revision. Specifically, we first compute, for a given firm at its target price announcement event, an estimate of the long-term equilibrium relation between target price and stock price by averaging all the ratios of target price to stock price up until the event day (denoted LT(TP/P)t).24 We require a minimum of 10 weekly observations to compute this estimate of the long-term ratio. Then, at the event-day, we obtain the already outstanding target price issued by the same brokerage house and measure how far this target price is from LT(TP/P)t. This distance is then scaled by the standard deviation of the firms long-term target price to price ratio. We denote this firm and event-specific measure by distanceit. We calculate event-day abnormal returns for each target price announcement as in Section III and then sort them into 12 different portfolios. These portfolios are constructed by first dividing the sample into two portfolios based on the sign of the deviation from the long-term ratio (distanceit is above/below the long-term ratio). Then, within each of these two portfolios, we form three additional portfolios based on the magnitude of the event-specific measure distanceit. Finally, each of the resulting six portfolios is further partitioned into two on the basis of the sign of the target price revision (upgrade/downgrade relative to the previous target price issued by the same broker). Table VII presents results of the analysis. Column (1) provides the three ranks of distanceit labeled "Smallest", "Intermediate", "Furthest". Columns (2) and (3) present average abnormal returns associated with target price revisions whose pre-event target price to market price ratio is below its long-term estimated level, conditional on the type of revision (i.e. upgrades or downgrades). Columns (4) and (5) present similar statistics for target price revisions whose pre-event target price to market price ratio is above its long-term estimated level.

24

Alternatively, we can calculate the time t long-term equilibrium relation between target price and stock price using the cointegration framework presented in section IV. Such computations, however, would involve enormous amount of time and computing power, as they require an estimation of the system of equations for each of the 900 stocks and each revision in a target price.

28

Consistent with our prediction, we find that, controlling for the type of news (i.e., target price upgrades or downgrades), average abnormal returns associated with target price revisions toward the estimated long-term target price to stock price ratio are smaller than those associated with revisions away from the long-term equilibrium relation. For example, the average abnormal return associated with a downward target price revision away from the long-term ratio is 2.514 percent (last row, column (2)). However, the average abnormal return associated with a

downward target price revisions towards the long-term ratio is 1.745 percent (last row, column (4)). Similarly, the average abnormal return when we consider upward revisions toward the long-term ratio is 1.160 percent compared with average abnormal return of 1.448 percent for upward revisions away from the long-term ratio. Standard t-tests for differences in means reject the null of equality for both comparisons (p-values equal to 0.001 and 0.031, respectively). These differences in abnormal returns are consistent with the market partially anticipating some of analysts' target price revisions. We further refine these results by sorting events based on the distanceit measure into three equal sized terciles. For example, in column (3), we take all events for which distanceit<0 and target price revisions were upgrades towards the long-term target to market price ratio. These events are then sorted based on their distanceit measure. We argue that price revisions in the "furthest" portfolio towards the long-term ratio are more predictable than similar revisions in the "smallest" distance portfolio and should therefore be associated with smaller abnormal returns. This is indeed the case. The abnormal return for the "smallest" distance portfolio is 1.370 while it is 0.987 percent for the "furthest" portfolio.25 Similarly, consider abnormal returns for target price revisions toward the long-term ratio for revisions whose target to market price ratio is currently above the long-term level (column 4). Revisions in the "furthest" portfolio, which are likely to be more predictable, are associated with a -1.493 percent average abnormal return, while abnormal return for revisions in the "smallest" distance portfolio, and therefore relatively unexpected, is -2.111 percent. Statistical tests for the
25

Target price revisions for theses portfolios are, on average, 0.4, 1.2, and 2.5 standard deviations away from the long-term ratio for the smallest, intermediate, and furthest portfolios, respectively (unreported in the table).

29

equality of means for the two comparisons reject the null of equality (p-values equal to 0.003 and 0.014, respectively). Results associated with the effect of distanceit for revisions away from the long-term relation are less conclusive. In particular, results in columns (2) and (5) suggest that market reaction to revisions away from the long-term ratio is only weakly related to the magnitude of the deviation from the long-term equilibrium ratio. Overall, however, the results in this section support the view that market participants are able to anticipate, at least partially, the direction of target price revisions.

VII. Conclusion and Future Research

Using a large database of analysts' target prices, stock recommendations, and earnings forecasts, we examine short-term market reactions to target price announcements and long-term co-movement of target prices vis--vis stock prices. Consistent with our predictions, we find that target prices are informative both unconditionally and conditional on a contemporaneously issued recommendation and earnings forecasts revisions. Recommendations and earnings forecast revisions are, however, also informative in the presence of target prices. Furthermore, we document a role for the degree of the recommendations change for a given target price change, suggesting that the degree of the stock recommendation revision conveys analysts' posterior uncertainty in the overall assessment of the firms prospects. In the second part of the analysis, we argue that while both sets of prices are nonstationary, cointegration of the two price series implies that there is a linear combination that is stationary and is termed as the long-term equilibrium of the price series. Intuitively, both variables are linked to the underlying firm fundamental value and therefore share a long-run common relationship. We capture this association by the ratio of target prices to market prices and provide direct evidence regarding both the magnitude of the long-term relationship and the dynamics that force the two sets of prices to converge to the long-run equilibrium. For a typical

30

firm, we find that in this equilibrium the one-year ahead target prices are 22 percent higher than current market prices. We also examine whether the long-term equilibrium is related to firm size and find that a typical small firm's target price is 27 percent higher than the contemporaneous market price while a large firm's target price is 19 percent higher than the market price. We find that these cross-sectional differences can be explained if we allow for mispricing uncertainty (Pastor and Stambaugh [1999]) about the Fama and French three-factor model. Furthermore, we provide evidence consistent with the hypothesis that target prices can be viewed as forecasts that are based on expectations that condition only on favorable outcomes over the forecast period. Finally, while market prices react to the information conveyed in analysts' reports, we show that once the system has been shocked away from this long-run equilibrium, the median half-life of the shock to the system is ten weeks. More importantly, we show that any subsequent correction towards the long-term equilibrium are done primarily by analysts, while market prices do not contribute much to this correction phase. We provide evidence that the market understands the latter relationship and therefore is able to anticipate, at least partially, analysts' target price revisions. Target prices have recently received considerable attention and have been subject to a great deal of criticism in the business press. Our paper is the first to explore and document evidence on their informativeness and time-series behavior. Our finding should serve as a starting point for further research on various related questions. For example, are there any crosssectional differences in market reaction based on firm and brokerage house characteristics? How do analysts determine their target prices? Are these prices based on a valuation model whose input includes their own earnings forecasts? What governs their decision to issue or withhold their target prices? What, if any, are the consequences on analysts' reputation for providing incorrect target prices or chasing the stock price? Are there any differences in target prices between "affiliated" and "unaffiliated" analysts (Michaely and Womack [1999])? Do analysts learn over time as in Mikhail, Walther, and Willis [1997]? We leave these interesting questions for future research.
31

Appendix
A. Additional Descriptive Statistics on the Recommendation and Target Price Databases In this Appendix we examine the frequency of inclusion of target prices in a brokerage houses report. While analysts' reports always include a recommendation, they do not necessarily include a target price. According to conversations with analysts, some brokerage houses have an explicit policy prohibiting their analysts from issuing target prices. In our sample, 135 of 325 brokerage houses do not issue any target price. Recommendations issued by these 135 brokerage houses account for about 5 percent of all recommendations.* Table A.I provides a transition matrix of brokerage house stock recommendations (the number on top in each cell) and the percentage of these recommendations issued with price targets (bottom number) for the period of 1997 to 1999. In computing the statistics, we

employed the following procedures: (1) all recommendations outstanding in the database for more than one year were assumed invalid; (2) the most recent brokerage house recommendation was assumed to have been reiterated for target price reports that were not accompanied by a corresponding recommendation observation in First Calls recommendation database. The validity of this procedure was confirmed with an official at First Call who indicated that since target price revisions are issued more frequently than recommendation revisions, many target price revisions are only recorded in the target price database and, as long as the corresponding recommendation remains unchanged, First Call does not reiterate the existing recommendation in the recommendation database (see also Krische and Lee [2000]). This criterion accounts for different number of observations between table I and table A.I. (3) Strong Sell and Sell recommendations were combined due their relatively small frequency in the data; (4) because
While we do not study the analyst's decision to omit a target price form the report, we conjecture several possible reasons. First, in many cases analysts simply do not derive a target price and based their recommendations on heuristics, relative valuation of a peer group, or some informal valuation model (see Stickel [2001] for determinants of stock recommendations). Second, even if the analyst derives a target price he may still choose to withhold it in circumstances where his cost of providing an ex-post incorrect price target exceeds the potential benefits from issuing it. For example, assume that analysts' compensation is related to the trading commissions that they generate and these, in turn, are generated mainly in recommending securities for purchase. Then, if incorrect target prices are, ex-post, costly, then analysts would tend to issue target prices mainly with Buy recommendations rather than with Sells.
*

some brokerage houses do not issue any target price reports, we only included in table A.I brokerage houses/firm combinations with at least one target price report. While results are qualitatively similar, removing the latter restriction reduces the off-diagonal percentages. Table A.I: Transition Matrix of Analysts' Stock Recommendations and Target Prices To Recommendation From Strong Buy Buy Hold Sell/Strong Sell Recommendation Strong Buy Buy Hold Sell/Strong Sell Initiated/Resumed as Overall
45,671 99% 6,108 60% 2,485 71% 63 56% 16,374 82% 70,701 91% 5,692 52% 36,823 99% 4,315 70% 86 60% 15,194 79% 62,110 88% 3,297 36% 5,186 35% 12,579 98% 424 41% 8,622 49% 30,108 66% 77 39% 114 40% 427 42% 527 92% 510 53% 1,655 61%

A number of interesting regularities are observed in this table. First, price targets are overall more likely to be issued along with Strong Buy or Buy recommendations (91 percent and 88 percent, respectively) than with Hold (66 percent) or Sell/Strong Sell (61 percent) recommendations. This is consistent with findings in Bradshaw [1999]. Second, within recommendation categories, a recommendation upgrade (below diagonal cells) is more likely to be accompanied by a price target than a recommendation downgrade (above diagonal cells). For example, price targets are included in 70 percent of the upgrade reports from Hold to Buy recommendations but only in 35 percent of the downgrade reports from Buy to Hold recommendations. This evidence is consistent with the common claim that analysts' are biased toward issuing favorable news and withholding (or minimizing) the amount bad news. The statistics on the diagonal indicate that virtually all recommendation reiterations include a target price. Since the typical duration of a stock recommendation is relatively long, analysts may

choose to convey new and perhaps more subtle information to the market via target price revisions and less frequently by recommendation revisions. Note that the high percentage of target prices on the diagonal is however partially driven by our assumption (2) above. Absent this assumption we find that about 50% of the recommendation reiterations are accompanied by a target price. Finally, analysts are more likely to initiate or resume coverage with a Strong Buy or a Buy recommendation and are also more likely to include a target price in those reports than with other recommendations. This is consistent with prior findings (e.g., McNichols and OBrien [1997], and Barber, Lehavy, McNichols and Trueman [2001]), and with the common claim that analysts are likely to avoid issuing recommendations and/or target prices when the cost of providing an ex-post incorrect assessment is likely to exceed the potential benefits from issuing such assessments.

B.

Derivation of Posterior Moments for the Mean Monthly Expected Excess Return This Appendix illustrates the formation of the prior beliefs for IBM's monthly expected

excess return, , and therefore prior beliefs on the annual expected return, b. The formation follows closely the procedure in Pastor and Stambaugh [1999] (hereafter "PS"). We refer the interested reader to their paper for a full-scale analysis and focus on four key steps that were taken with emphasis on the subtleties of their approach. The four steps are summarized as follows.

Step 1: Derivation of Posterior Beliefs of IBM's Three-factor Loadings Recall that our price data begins in January 1997. Hence, we are interested in generating investor's beliefs in the period immediately prior to this month. Specifically, we form the Bayesian investors posterior beliefs using data from the five-year period from January 1992 to 1996. We obtain, from CRSP, all firms traded on the NYSE, AMEX, and NASDAQ with at least 24 continuous monthly returns over this period (6,626 firms). Then, we estimate firm specific

three-factor ordinary least-squares regressions and record the firms' intercepts, factor loadings, (the elements in the vector (see equation (7) above)), and residual standard deviations, denoted

.
The grand average of the vector of factor loadings, , and the grand average of the estimated residual standard deviations serve as the central tendencies towards which IBM's ordinary least-squares estimates of and residual standard deviation are shrunk (pulled) towards. The strength of the shrinkage is governed by 's prior variance-covariance matrix. We construct this matrix as in PS (see pages 76-78) and impose that this matrix be diagonal to ensure positivedefiniteness. Table B.I provides the parameters governing prior beliefs, and is structured as in PS (see their Table I, Panel A). Note that prior beliefs regarding the intercept, 0, are centered at zero and the standard deviation about this central tendency, 0 , is allowed to vary. Consequently, with large uncertainty about a zero intercept, the investor is allowed to form posterior beliefs that permit a certain amount of mispricing. For example, IBM's estimate of the intercept is 2.09 percent per month so unless the investor has a dogmatic belief in lack of mispricing ( 0 = 0 ) his posterior beliefs regarding mispricing will be centered on positive values and away form the zero null. While the preceding investor's prior beliefs allow for mispricing, PS provide a framework within which prior beliefs in large intercepts are associated with high levels of residual standard deviation and thus reduce the possibility of trading strategies with high Sharpe ratios. Table B.I: Specification of Parameters in Prior Beliefs 's Prior Parameters 's Prior Parameters Sum of i i Correlation Matrix d.f. squares 0 0- 1 0 0 0 5 0.0111 0.973 0.366 1 0 0 0.970 0.821 1 0 0.295 0.739 1

0 1 2 3

Following Bayes Theorem, posterior beliefs on IBM's parameters are generated by combining the information from the prior with the likelihood function for the firm returns (assumed to be i.i.d. Normal). We simulate draws from this distribution using the Gibbs Sampler and the Griddy Gibbs.* Table B.II provides the resulting posterior beliefs and is structured as in PS's Table III, Panel A. Specifically, we report the posterior means and standard deviations of IBM's model parameters for three possible levels of mispricing uncertainty, 0 . The first level captures dogmatic beliefs in the three-factor model. The second value of 0 is one percent. It is equal to the cross-sectional standard deviation of intercepts from the universe of stocks with which we constructed the prior beliefs in step 1. The last level is set at a high value, 10 percent, and is meant to capture strong beliefs in the possibility of model mispricing. To illustrate the effect shrinkage we also provide, in last column, IBM's ordinary least-squares estimates and their standard deviations. Table B.II: Moments of Regression Parameters' Posterior Distributions Prior Standard Deviation of 0, 0 Posterior Mean: OLS 0% 1% 10% 0.000 0.004 0.017 0.021 0 1.016 0.991 0.884 0.694 1 0.515 0.495 0.451 0.296 2 -0.216 -0.243 -0.364 -0.636 3 0.072 0.071 0.068 0.064 Posterior Std.: 0.000 0.005 0.009 0.009 0 0.260 0.263 0.266 0.361 1 0.338 0.336 0.331 0.336 2 0.338 0.341 0.345 0.366 3 0.005 0.005 0.005 0.001 The first row in the Table demonstrates how increasing levels of beliefs about model mispricing (increasing 0 ) lead to a higher posterior mean for 0 that is closer to the ordinary

We simulate 1,100 draws from the joint posterior and discard the first 100. We have checked that increasing the number of draws to 10,100 results in the same posterior moments. For a brief description Gibbs sampling see Appendix D.

least-squares estimate. The remaining rows give the posterior means and standard deviations for the remaining factor loadings. For example, shrinkage pulls IBMs ordinary least squares estimate of market beta, 0.694, towards the prior which is centered at unity (see Table B.I).

Step 2: Derivation of Posterior Beliefs for Factor Premiums

Recall that IBM's monthly expected excess return , is given by = 1 ' . We have derived posterior beliefs regarding and now turn our attention to the derivation of posterior beliefs for the factor risk premiums . PS begin by specifying a noninformative prior for 's

[ ]

prior mean and variance covariance. The factor returns are assumed to be distributed i.i.d. Normal. We form posterior beliefs following PS (page 83). In addition, we incorporate

additional information from other variables, with longer return histories, which are correlated with the three factors. PS employ three such variables, the first is the return on the NYSE valueweight index, the second is the return on the NYSE equal-weight index, and the return on the smallest size-decile portfolio, all monthly return series begin in 1926 and were obtained from CRSP. Table B.III provides posterior means and standard deviations for each of the three factor premiums. Table B.III: Moments of Factor Premiums' Posterior Distributions RMRF SMB HML Mean 0.0047 0.0037 0.0044 Standard Deviation 0.0019 0.0014 0.0012

Step 3: Derivation of Posterior Beliefs for IBM's Expected Excess Return From the previous two steps we now have the investor's posterior beliefs for both and . PS show how to combine these beliefs to form posterior beliefs for , IBM's monthly expected excess return. The resulting posterior moments are given in Table B.IV as a function of mispricing uncertainty 0 .

Table B.IV: Moments of , IBM's Monthly Expected Excess Return Posterior Distribution Prior Standard Deviation of 0, 0 Mean Standard Deviation 0% 0.0058 0.0037 1% 0.0097 0.0051 10% 0.0223 0.0093

Moving from left to right it is clear that stronger beliefs in model mispricing result in a higher posterior mean for . For example, ruling out any mispricing, the investor's posterior mean, at the end of 1996 and having observed five years worth of monthly returns on IBM, is 58 basis points. However, with 0 equals one percent 's posterior mean is 97 basis points.

Step 4: Derivation of IBM's Annual Expected Return Our final step is to convert the monthly excess expected return into an annual expected return. We convert the posterior distribution of monthly expected excess return into a monthly expected return distribution by adding an estimate of a one-month risk-free rate. We avoid, For simplicity, the modeling of investor's beliefs regarding the one-month risk-free return and assume that it is the average return, over the five year period from 1992 through the end of 1996, on the one-month T-bill return (34 basis points). Next, we want to generate a distribution for monthly returns that takes into account the uncertainty in . To this end, we simulate 1,000 draws form the posterior distribution and then compound (one plus) each of the draws twelve times to arrive at 1,000 annual buy-and hold returns for IBM. The resulting distribution, we maintain, captures our investor's prior beliefs regarding IBM expected annual return. In our empirical implementation we choose to approximate this simulated distribution with a continuous Normal distribution for two reasons. First, the approximation simplifies the computations that we conduct later. Second, the support of the distribution is not truncated unlike the support of the simulated distribution. The Normal distribution's mean and variance are set

equal to the simulated distribution's moments. Table B.V presents the moments of this distribution as a function of mispricing uncertainty.

Table B.V: Moments Used in Prior Beliefs Regarding IBM's Annual Expected Return Prior Standard Deviation of 0, 0 Posterior Mean Posterior Std. 0% 0.117 0.049 1% 0.171 0.070 10% 0.363 0.149

It can be seen that with dogmatic beliefs in the accuracy of the three-factor model the investor's prior beliefs regarding the expected annual return are centered at 11.7 percent with 4.9 percent standard deviation. Hence, in this case our prior, p(b ) , is taken as Normal distribution with a mean at 1.117 to reflect the investor's prior belief that, in the long-run equilibrium, the ratio of target prices to market prices is 11.7 percent. As mispricing uncertainty increases we know that the investor allows for the possibility of mispricing which, in IBM's case, leads to a higher expected annual return and standard deviation. For example, when mispricing uncertainty,

0 , is 1 percent the investor's prior beliefs are centered at 17.1% and therefore indicate that she
expects the ratio of target prices to market prices to equal 1.171.

C.

Derivation of Regression Parameter's Posterior Beliefs We derive b's posterior distribution, p(b ) , following Bauwens and Lubrano [1996]

(pages 12-14) The joint posterior distribution is integrated with respect to the elements in B and
whose conditional distributions are in the form of a Matrix-T and Inverse Wishart

respectively (see Zellner [1971]). It is proportional to: p(b ) p0 (b ) where W0 = Z ' M X Z , M X = IT X X ' X 'W0 W1
' l0 l1

(A1)

W1 = Z ' M X I T Y Y ' M X Y

Y ' M X Z . We draw from this distribution using the same technique

X ' , l 0 = (T k r n ) / 2 , l1 = (T k r ) / 2 , and

as in the Griddy Gibbs, which is described in Appendix D.

Next, note that p(B ) is in the form of a matrix-T distribution and, B = ' . We
'

( )

make use of the properties of a matrix-T distribution, and derive the conditional distribution of ,
p ( ) . For completeness, we write p(B ) as follows:

~ ~ '~ ~ p (B ) ~ Matrix - T W 'W , S , B, T k r S + B B W 'W B B

T / 2

(A2)

~ ~ where B = W 'W

Appendix B.5), p ( ) is in the form of a multivariate student-t distribution,

1 ' p ( ) 1 + ( ) V 1 ( )
+2 2

~ ~ ' ~ W 'Y and S = Y WB Y WB . Following Zellner [1971] (Section 8.1 or

)(

(A3)

1 where is a (2 x 1) vector taken from the last column in B . = T k 2 , V = S , and f 1 ~ ~ ~ ~ f = Z ' Z Z ' X X ' X X ' Z . We obtain draws from the marginal distribution of , p( ) , by
drawing repeatedly from p(b ) and then drawing from the conditional p( ) . The resulting draws are, in effect, draws from p( ) . Finally, B 's conditional distribution was given in equation (A2) as a Matrix-T from the conditional p(B ) . Draws from 's marginal posterior distribution are obtained by distribution. Draws from it can be obtained by repeatedly drawing from p(b ) and then drawing

~ ' ~ noting that it is in the form of an inverse Wishart distribution with parameters Y WB Y WB

)(

and T degrees of freedom, conditional on B and . Thus, we can obtain draws from 's marginal distribution since the marginal distributions of B and are already available.

D.

Gibbs Sampling and Griddy Gibbs The idea behind the Gibbs sampler is as follows. Suppose that we are interested in the

posterior distribution of a vector of unknown random parameters = (1 , 2 ,K, d ) . Denote by

i () the conditional posterior distribution of i . Then starting with an initial starting point = 0 , 02 ,K, 0d , the algorithm iterates the following loop: 1
i a. Sample 1+1 from p 1 i2 ,K, id

b. Sample i2+1 M

( from p ( (

i 1+1 , i3 ,K, id

i 1 d . Sample id+1 from p d 1+1 ,K, id+1

The vectors 0 , 1 ,Kt ,K are a realization from a Markov Chain. It can be shown (Geman and Geman [1984]) that the joint distribution of

( ,K, )
i i
1 d

converges to

p (1 ,K, d DATA) i.e. the joint posterior distribution, as i under mild regularity

conditions. For applications of the Gibbs sampler see Kandel, McCulloch, and Stambaugh [1995], Gelfand, Hills, Racine-Poon, and Smith [1990], and Brav [2000]. Since the conditional distribution of the firm factor loadings is not available in a known analytical form, we use the Griddy Gibbs approach to sample from this distribution (see Ritter and Tanner [1992], Tanner [1996]). In particular, we adopt the following approximation:

1. Evaluate the density on a grid of M points . This yields a vector {p1 , p2 ,K, pM }. 2. Use the vector {p1 , p2 ,K, pM } to obtain an approximation of the inverse cdf of p( ). 3. Sample from a Uniform distribution Un([0,1]) and transform the observation via the approximation in step 2.

Figure I: Average buy and hold abnormal return around announcements of target price by portfolios ranked on the basis of the magnitude of the target price revision, 1997 to 1999
5.0 Buy and hold abnormal return for portfolios ranked by TP/P 4.0 3.0 2.0 Market-Adjusted Return 1.06 1.0 0.0 -0.78 -1.0 -2.0 -2.16 -3.0 -2.88 -4.0 -3.96 -5.0 Lowest 2 3 4 5 6 7 8 9 Highest Deciles of Target Price Revision -0.44 -1.66 -0.89 -1.30 -0.19 0.04 0.57 0.22 0.53 0.16 0.73 1.82 1.18 0.99 1.24 Buy and hold abnormal return for portfolios ranked by TP/P Buy and hold abnormal return for portfolios ranked by (TP-ConsTP)/P 2.65 1.89 1.53 1.30 1.03 2.61 3.21

1.60 1.43 1.70

Figure II: IBM's Weekly Stock Price, Target Price, and Target Price to Price Ratio, 1997 to 1999
This figure depicts weekly market price and consensus target price for IBM. The market prices are from CRSP and the weekly consensus target price is the average of all outstanding target prices issued over the preceding days ninety days. All target prices are from the First Call database. We also plot the ratio of the target price to market price at each point in time denoted by TP/P. The vertical axis on the left-hand-size corresponds to the price series while the axis on the right-hand-size corresponds to the TP/P ratio. 160 2

140

1.8

IBM's Target Price/Price Ratio

120

1.6

Stock Price and Target Price ($)

1.4

1.2

80

IBM's Consensus Target Price

60

0.8

0.6 40

IBM's Stock Price

20

0.4

0.2

0
970106 970203 970303 970331 970428 970527 970623 970721 970818 970915 971013 971110 971208 980105 980202 980302 980330 980427 980526 980622 980720 980817 980914 981012 981109 981207 990104 990201 990301 990329 990426 990524 990621 990719 990816 990913 991011 991108 991206

Date

Target Price / Price

100

Table I: Descriptive Statistics on Analysts' Price Targets, Stock Recommendations, and Earnings Forecast Revisions 1997-1999
This table reports statistics on the First Call price target (Panel A), stock recommendation ((Panel B), and earnings forecast (Panel C) data for firms with available data on CRSP. To ensure accurate dating of analysts' reports, we include only observations coded as Real-time (i.e., reports received from live feeds such as the broker note and are dated as the date that the report was published). The panels present, by year, the number of observations, the average number of reports per firm, the number of firms, the number of brokerage houses issuing reports, and the mean number of brokerage houses per firm. The last row in each panel presents statistics for the three-year sample period. For example, in panel A, the sum total of all target price observations is 223,016 and the number of distinct firms covered is 6,544.

Panel A: Target Prices

Year
(1)

Price Targets Avg. No. N Per Firm

(2) (3)

Number of Firms N
(4) (5)

Brokers Avg. No. Per Firm

(6)

1997 1998 1999 Overall

49,134 79,936 93,946 223,016

10 16 18 14

4,694 4,997 5,165 6,544

123 136 149 190

4 5 5 6

Panel B: Stock Recommendations

Year
(1)

Recommendations Avg. No. N Per Firm

(2) (3)

Number of Firms N
(4) (5)

Brokers Avg. No. Per Firm

(6)

1997 1998 1999 Overall

32,295 42,805 42,014 117,114

6 7 7 6

5,572 5,871 5,929 8,673

211 222 210 325

4 5 5 7

Panel C: Earnings Forecasts

Year
(1)

Earnings Forecasts Avg. No. N Per Firm

(2) (3)

Number of Firms N
(4) (5)

Brokers Avg. No. Per Firm

(6)

1997 1998 1999 Overall

39,736 42,228 42,322 124,286

6 7 7 7

6,474 6,203 6,106 9,167

204 233 246 282

5 5 5 7

Table II: Statistics on Target Prices by Analyst Stock Recommendations, 1997 to 1999
This table provides descriptive statistics on the target price information measures. Panel A provides general distributional statistics while Panel B provides information conditional on stock recommendation revisions. The information content measures are (i) the ratio of target price to pre-announcement stock price (stock price outstanding two days prior to the announcement of the target price), denoted (TP/P), (ii) the change in the individual brokerage house target price scaled by pre-announcement stock price, denoted (TP/P), and (iii) the difference between the brokerage house and the pre-announcement consensus target price, scaled by pre-announcement stock price, denoted (TP-ConsTP)/ P). Earnings forecast revision is computed as the difference in the brokerage house current and prior annual earnings forecast scaled by pre-announcement stock price. All prices and eanings are converted to the same split-adjusted basis.

Panel A: Descriptive statistics on measures of the information content of target price

Target price to Stock Price Ratio (TP/P) Change in Brokerage House BH Target Price (TP/P) Change in Target Price Relative to PreForecast Revision announcement Consensus Target Price

Mean Max th 75 percentile Median 25th percentile Min Standard Deviation N

1.329 3.004 1.433 1.255 1.146 0.584 0.304 204,031

17.5% 122.6% 50.0% 12.3% -5.4% -169.7% 42.4% 77,594

11.5% 120.8% 27.6% 5.1% -7.3% -119.6% 35.8% 181,025

-0.41% 35.2% 0.16% -0.03% -0.43% -422.5% 2.5% 82,052

Panel B: Mean target price to price ratio (TP/P)

To Recommendation From Recommendation Strong Buy Buy Hold Sell/Strong Sell Initiated/Resumed as Overall Strong Buy 1.40 1.41 1.37 1.42 1.43 1.41 Buy 1.30 1.31 1.31 1.36 1.31 1.31 Hold 1.18 1.12 1.16 1.11 1.15 1.16 Sell/Strong Sell 1.04 1.21 1.01 1.03 1.07 1.04

Panel C: Mean change in individual brokerage house's target price, scaled by price (TP/P)
To Recommendation From Recommendation Strong Buy Buy Hold Sell/Strong Sell Initiated/Resumed as Overall Strong Buy 22.0% 25.8% 28.7% 28.0% NA 22.3% Buy -0.4% 17.2% 21.2% 16.3% NA 16.3% Hold -11.0% -5.9% 5.4% 11.8% NA 3.1% Sell/Strong Sell -33.9% -7.9% -16.1% -0.8% NA -5.8%

Panel D: Mean difference between brokerage house and consensus target price, scaled by price ((TP-ConsTP)/P) To Recommendation
From Recommendation Strong Buy Buy Hold Sell/Strong Sell Initiated/Resumed as Overall Strong Buy 17.3% 19.9% 19.2% 14.6% 16.3% 17.3% Buy 2.6% 10.3% 12.5% 5.3% 8.0% 9.7% Hold -5.7% -6.3% -5.2% -4.7% -7.3% -5.6% Sell/Strong Sell -24.1% -7.2% -19.4% -18.9% -19.9% -18.9%

Table III: Market-Adjusted Return around Announcements of Target Prices , 1997 to 1999
This table provides average buy and hold abnormal returns for the period from two days prior to through two days subsequent to the announcement of target price for decile portfolios ranked on the basis of three target price information measures. Abnormal returns are computed as the difference between the firm buy and hold return and the buy and hold return on the NYSE/AMEX/NASDAQ value weight index. The information content measures are (i) the ratio of target price to pre-announcement stock price (stock price outstanding two days prior to the announcement of the target price), denoted (TP/P) (columns (2) through (4)), (ii) the change in the individual brokerage house target price scaled by pre-announcement stock price, denoted (TP/P) (columns (5) through (7)), and (iii) the difference between the brokerage house and the preannouncement consensus target price, scaled by pre-announcement stock price, denoted (TP-ConsTP)/ P) (columns (8) through (10)). To avoid possible cross-correlation problem due to identical return observations, we delete all but one of identical return observations within each portfolio.

TP/P Portfolios
(TP/P equals the ratio of target price to preannouncement stock price, N=195,563)

TP/P Portfolios
(TP/P is the change in the individual brokerage target price scaled by pre-announcement stock price, N=73,816) Mean Ranking Variable
(5)

(TP-ConsTP)/P Portfolios
((TP-ConsTP)/P is the change in the brokerage house target price relative to pre-announcement consensus target price scaled by preannouncement stock price, N=168,634) Mean Ranking Variable
(8)

Portfolio

Mean Ranking Variable

(2)

Abnormal Return (%) Mean

(3)

Abnormal Return (%) Mean

(6)

Abnormal Return (%) Mean

(9)

t-statistic
(4)

t-statistic
(7)

t-statistic
(10)

(1)

Lowest 2 3 4 5 6 7 8 9 Highest

0.96 1.09 1.15 1.19 1.23 1.28 1.35 1.44 1.59 2.03

-1.660 -0.784 -0.193 0.222 0.727 0.990 1.176 1.434 1.298 1.032

-27.08 -16.38 -4.18 4.62 14.46 18.18 19.64 22.12 18.34 13.13

-0.64 -0.19 -0.06 0.04 0.09 0.16 0.29 0.50 0.65 0.88

-3.956 -2.877 -1.296 0.572 1.064 1.817 2.654 1.599 1.886 3.208

-29.41 -27.48 -16.07 7.87 13.70 20.88 25.94 16.54 21.52 29.99

-0.49 -0.17 -0.07 -0.01 0.03 0.08 0.15 0.29 0.54 0.82

-2.164 -0.887 -0.441 0.038 0.162 0.532 1.241 1.696 1.525 2.608

-26.57 -13.81 -7.79 0.69 3.05 9.82 21.08 25.60 24.45 37.68

Table IV: Relative Informativeness of Stock Recommendations, Target Price Revisions, and Earnings Forecast Revisions
This table reports results for regressions of market-adjusted return around target price announcements on indicator variables for analysts' recommendation level/revisions, target price revision, and earnings forecast revision. The indicator variables assume the value of 1 for the relevant recommendation level/revisions and 0 otherwise. The recommendation categories are Hold, Buy, Strong Buy (Panel A), upgrades, downgrades, and reiterations (Panel B), and recommendation revisions (Panel C). Each panel also reports p-value of a test of equality of the intercept indicators. Abnormal return (AR) is computed as the difference between the firm buy and hold return and the buy and hold return on the NYSE/AMEX/NASDAQ value weight index over the period beginning two days prior to and ending two days subsequent to the target price announcement. Earnings forecast revision is computed as the percentage change in the brokerage house current and prior annual earnings forecast scaled by pre-announcement stock price (denoted DF/P). Target price revision is measured as the change in the brokerage house target price, scaled by pre-announcement stock price (denoted DTP/P). We winsorize DF/P and DTP/P at the 1st and 99th percentiles to mitigate the possible effect of extreme observations. In addition, we verify that regression results are not sensitive to influential observations. The number of observations in each regression is 48,700.

Variable
(1)

Coefficient Estimates
(2)

t-statistic
(3)

(4)

Panel A: AR = a1HOLD + a2BUY + a3SB + bDF/P + g DTP/P + e a1 (Hold) a2 (Buy) a3 (Strong Buy) b (DF/P) g (DTP/P) p-value for test of a1=a2=a3 -1.166 -0.238 0.208 0.828 4.312 -11.2 -3.8 3.5 19.4 46.5 0.000 6.9%

Panel B: AR = a1Upgrades + a2Downgrades + a3Reiterations + bDF/P + gDTP/P + e a1 (Upgrades) a2 (Downgrades) a3 (Reiterations) b (DF/P) g (DTP/P) p-value for test of a1=a2=a3 2.486 -3.495 -0.114 0.811 4.207 15.4 -20.4 -2.6 19.2 45.7 0.000 7.8%

Panel C: AR=a1HOLDtoSB+ a2BUYtoSB+a3HOLDtoBUY+a4SBtoHOLD+a5SBtoBUY+a6BUYtoHOLD+a7SBtoSB

+a8BUYtoBUY+a9HOLDtoHOLD+bDF/P+gDTP/P+e

a1 (Upgrades from Hold to Strong Buy) a2 (Upgrades from Buy to Strong Buy) a3 (Upgrades from Hold to Buy) a4 (Downgrades from Strong Buy to Hold) a5 (Downgrades from Strong Buy to Buy a6 (Downgrades from Buy to Hold) a7 (Strong Buy reiterations) a8 (Buy reiterations) a9 (Hold reiterations) b (DF/P) g (DTP/P) p-values for tests of: a1=a2 (HOLDtoSB=BUYtoSB) a1=a3 (HOLDtoSB=HOLDtoBUY) a4=a5 (SBtoHOLD=SBtoBUY) a4=a6 (SBtoHOLD=BUYtoHOLD)

3.276 2.246 2.533 -4.485 -3.109 -3.536 0.023 -0.120 -0.580 0.793 4.161

8.5 10.6 8.0 -11.7 -13.0 -11.2 0.4 -1.8 -5.1 18.7 45.0 0.024 0.139 0.008 0.056

7.9%

Table V: Long-Rum Equilibrium Relation between IBMs Target Price and Stock Price
The table provides regression results of the cointegration analysis. The sample is 151 weekly observations of target and market prices spanning the period January 1997 through December 1999. The target price series is formed by equal-weighting all outstanding target prices that were issued within the previous 90 days. The regression setup is given in Section IV.A. The two panels provide posterior moments for the parameter b, that captures the long-run ratio of target prices to market prices, and the vector the , that contains the response coefficients of each price variable to deviations from the long-run equilibrium. The panels differ in the specification of the prior beliefs in model mispricing (see Section IV.B and Appendix B). Panel A corresponds to prior beliefs that negate any mispricing and impose dogmatic beliefs in the exact pricing ability of the three-factor model. In particular, the prior mean and standard deviation of the regression's intercept Normal distribution with mean

0 , 0 are set to zero. The resulting prior, p0 (b ) , is a

resulting prior, p0 (b ) , is a Normal distribution with mean b = 17.1, standard deviation b = 7.08%. The first row in each panel provides the posterior mean of the parameters while the second row provides the posterior standard deviation.

b = 11.7%, standard deviation b = 4.9%. In Panel B we allow for investor's beliefs in possible mispricing by setting 0 = 1% while keeping the prior mean of mispricing, b , at zero. The

Panel A: Mispricing is ruled out. Prior moments of long-run ratio b Mean Std 1.117 0.049 Posterior Moments of: Target Prices Response tp (%) 21.9 4.1

long-run ratio b 1.204 0.017

Market Prices Response market (%) 3.3 5.1

Panel B: Mispricing uncertainty is entertained. Prior moments of long-run ratio B Mean Std 1.171 0.0708 Posterior Moments of: Target Prices Response tp (%) 22.0 4.4

long-run ratio b 1.215 0.017

Market Prices Response market (%) 3.1 5.3

Table VI: Full Sample Cointegration Analysis

The sample is 900 firms with at least one year of continuous record of weekly target and market prices over the period January 1997 through December 1999. For each firm we form the target price series by equal-weighting all outstanding target prices that were issued within the previous ninety days. The regression setup is given in Section IV.A. The table provides summary statistics of posterior moments for the parameter b, that captures the long-run ratio of target prices to market prices, and the vector the , that contains the response coefficients of each price variable to deviations from the long-run equilibrium. We present results for the specification of prior beliefs that negate any mispricing and impose dogmatic beliefs in the exact pricing ability of the three-factor model (prior mean of regression's intercept

0 = 0, and prior standard deviation 0 = 0).

The first panel

provides information regarding posterior means. The first row provides averages and standard deviations of posterior means for all 900 firms. For example, the grand-average of all b's prior means is 1.15 and the cross-sectional standard deviation of these prior means is 0.04. The grand-average of the posterior means is equal to 1.22 and the cross-sectional standard deviation of these posterior means is 0.07. In the next five rows we split the sample into size quintiles and report similar statistics as in the first row. Panel B provides information regarding posterior standard deviations. For example, the grand-average of all b's prior standard deviations is 5.8 percent and the cross-sectional standard deviation of these posterior standard deviations is 1.5 percent. The grand-average of the posterior standard deviations is equal to 3.5 percent and the cross-sectional standard deviation of these posterior standard deviations is 1.8 percent.

Panel A: Means of Prior and Posterior Distributions Portfolio Number of firms (2) 900 76 115 183 224 302 Prior Mean Long-Run Ratio b Avg Std (3) (4) 1.15 0.04 1.18 0.03 1.17 0.03 1.17 0.04 1.15 0.04 1.13 0.04 Posterior Mean Long-Run Ratio b Avg (5) 1.22 1.27 1.25 1.24 1.22 1.19 Std (6) 0.07 0.06 0.06 0.06 0.06 0.06 Target Prices Response tp (%) Avg (7) 8.9 7.6 8.2 8.1 8.9 9.9 Std (8) 4.3 5.0 4.1 3.4 4.0 4.6 Market Prices Response market (%) Avg (9) -1.5 -2.2 -1.6 -1.5 -1.2 -1.5 Std (10) 4.1 3.5 3.8 3.3 4.0 4.7

(1) All Firms Small 2 3 4 Large

Panel B: Standard Deviations of Prior and Posterior Distributions Number of firms Prior Standard deviation Long-Run Ratio b (%) Avg Std (3) (4) 5.8 1.5 7.3 0.9 6.9 1.1 6.5 1.2 5.6 1.4 4.7 1.2 Posterior Standard Deviation Long-Run Ratio b Avg (5) 3.5 5.4 4.4 3.9 3.2 2.6 Std (6) 1.8 2.2 2.0 1.7 1.3 1.2 Target Prices Response tp (%) Avg (7) 2.5 2.6 2.4 2.4 2.4 2.5 Std (8) 0.9 1.1 0.7 0.8 0.8 1.0 Market Prices Response market (%) Avg (9) 3.7 3.4 3.4 3.5 3.6 4.2 Std (10) 1.2 1.4 1.0 1.0 1.1 1.3

Portfolio

(1) All Firms Small 2 3 4 Large

(2) 900 76 115 183 224 302

Table VII: Conditional Abnormal Returns At Target Price Announcements

For each firm with a minimum of 10 weekly observations we compute, at its target price announcement, an estimate of the long-term equilibrium relation between target price and stock price by averaging all the ratios of target price to stock price up until the event day. Then, at the event-day, we obtain the already outstanding target price issued by the same brokerage house and measure how far is this target price from its long-term equilibrium relation. This distance is then scaled by the standard deviation of the firms long-term target price to stock price ratio. We denote this firm and event specific measure by distanceit. We then calculate event-day abnormal returns for each target price announcement and sort them into 12 different portfolios. These portfolios are constructed by first dividing the sample into two portfolios based on the sign of the deviation from the long-term ratio (distanceit is above/below the long-term ratio). Next, within each portfolio, we form three sub-portfolios based on the magnitude of the event-specific measure distanceit. Finally, each of the resulting six portfolios is further partitioned into two on the basis of the sign of the target price revision (upgrade/downgrade relative to the previous target price issued by the same broker). We report the average abnormal return for each of the resulting 12 portfolios. Column (1) provides the three ranks of distanceit labeled "Smallest", "Intermediate", "Furthest". Columns (2) and (3) present average abnormal returns associated with target price revisions whose pre-event target price to market price ratio was below its long-term estimated level, by the type of revision (i.e. downgrade or upgrade). Columns (4) and (5) present similar statistics for target price revisions whose pre-event target price to market price ratio was above its long-term estimated level. Pre-revision TP/P is below its long-term TP/P relation (distanceit<0) Target price revisions away Target price revisions toward from long-term TP/P long-term TP/P (downgrades) (upgrades) (2) (3) -2.428 -2.978 -1.787 -2.514 1.370 1.188 0.987 1.160 Pre-revision TP/P is above its long-term TP/P relation (distanceit>0) Target price revisions toward Target price revisions away long-term TP/P from long-term TP/P (downgrades) (upgrades) (4) (5) -2.111 -1.846 -1.493 -1.745 1.465 1.560 1.115 1.448

Distance of pre-revision TP/P to long-term TP/P (1) Smallest Intermediate Furthest Overall

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