Identifying Consensus Analysts' Earnings Forecasts that Correctly and Incorrectly Predict an Earnings Increase

This study observes that consensus analysts' forecasts incorrectly predict an increase in one-year-ahead earnings in 28.9% of the firm-year observations, and that correct (incorrect) firms generate 14.8% (-25.7%) abnormal returns over the next year, on average. The ability to anticipate when analysts' predicted earnings increases will or will not materialize is therefore potentially important to investors and investment fund managers. This paper develops an empirical model that predicts when analysts' forecasts will correctly (versus incorrectly) anticipate the direction of the change in upcoming earnings, by exploiting information in (a) the nature of analysts' characteristics and firms' earnings predictability, and (b) fundamental analysis of firms' earnings growth. The model successfully distinguishes between forecasted earnings increases that do (versus do not) materialize and a trading strategy that takes long (short) positions in the portfolio the model identifies as more (less) likely correct generates an average annual abnormal return of 14.1%.