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Do analysts correct the market's mispricing of accruals?

Yong Keun Yoo, 2004
Faculty Advisor: Stephen Penman

Abstract

Elgers, Lo and Pfeiffer (2003) argue that the bias of analysts' earnings forecasts is significantly less than the bias of market's earnings expectations in interpreting accruals. Their argument implies that analysts' earnings forecasts could potentially mitigate the market's mispricing of accruals by guiding investors to reduce their earnings prediction errors arising from the misinterpretation of accruals. However, their results call for further investigation owing to the following two questionable research design choices: (1) estimating the magnitude of the market's bias by using the framework of the Mishkin test based on the earnings response coefficient model, which is vulnerable to the well-known omitted-variable problem; (2) comparing only the bias of one-year-ahead earnings expectations, while ignoring the bias of earnings expectations for longer periods. By taking an alternative approach to address these issues, I find that analysts' earnings forecasts are more biased than stock prices in interpreting accruals. Thus, contrary to Elgers et al. (2003), I conclude that analysts' earnings forecasts do not mitigate the market's mispricing of accruals.

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