Further evidence on optimism and underreaction in analysts' forecasts

In this paper, we argue that the observed optimism in analysts' forecasts of earnings is related to the costs and benefits to analysts of issuing optimistic forecasts — when the costs of issuing an optimistic forecast are high relative to the benefits of doing so, optimism will be less apparent or absent. We also argue that underreaction to past forecast errors and past changes in earnings is most evident when earnings components are viewed as permanent. We test our arguments by examining the properties of analysts' forecasts for two samples of distressed firms: (1) firms that file for bankruptcy and (2) firms that experience financial distress but turnaround. According to our arguments, for bankrupt firms, optimism should become less apparent or absent as bankruptcy approaches. Further, for these (bankrupt) firms, underreaction to past forecast errors and past changes in earnings should persist during the period of financial distress. For turnaround firms, we predict the opposite results. We find that the bias in forecasts for the bankrupt sample declines to insignificant levels by the year prior to bankruptcy filing. Forecast bias for the turnaround sample disappears in the year of recovery and is absent during the first half of the following year. For the bankrupt sample, we find evidence of underreaction to past errors in the 4 years prior to the bankruptcy filing; this underreaction is driven by firms with negative earnings‐to‐price ratios. Underreaction to past errors for the turnaround sample disappears in the year of recovery and is absent in the two subsequent years. Unlike past research, we do not find analysts' forecasts to be correlated with past earnings changes. Overall, our results support our cost–benefit and permanence of earnings arguments.