Tuesday, April 13, 2010

Equity Analysts Still Too Bullish

After almost a decade of stricter regulation, analysts’ earnings forecasts continue to be excessively optimistic.

McKinsey Quarterly

APRIL 2010 • Marc Goedhart, Rishi Raj, and Abhishek Saxena

Corporate Finance, Performance article, Equity analysts Still too bullish

No executive would dispute that analysts’ forecasts serve as an important benchmark of the current and future health of companies. To better understand their accuracy, we undertook research nearly a decade ago … . Analysts, we found, were typically overoptimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined.1

…[A] recently completed update of our work …reinforces this view—despite a series of rules and regulations … that were intended to improve the quality of the analysts’ long-term earnings forecasts, restore investor confidence in them, and prevent conflicts of interest.2 For executives, …this is a cautionary tale worth remembering.

Exceptions to the long pattern of excessively optimistic forecasts are rare, as a progression of consensus earnings estimates for the S&P 500 shows (Exhibit 1). Only in years such as 2003 to 2006, when strong economic growth generated actual earnings that caught up with earlier predictions, do forecasts actually hit the mark. This pattern confirms our earlier findings that analysts typically lag behind events in revising their forecasts to reflect new economic conditions. When economic growth accelerates, the size of the forecast error declines; when economic growth slows, it increases.3

Moreover, analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year,4 compared with actual earnings growth of 6 percent.5 Over this time frame, actual earnings growth surpassed forecasts in only two instances, both during the earnings recovery following a recession (Exhibit 2). On average, analysts’ forecasts have been almost 100 percent too high.6

Capital markets, on the other hand, are notably less giddy in their predictions. Except during the market bubble of 1999–2001, actual price-to-earnings ratios have been 25 percent lower than implied P/E ratios based on analyst forecasts (Exhibit 3). What’s more, an actual forward P/E ratio7 of the S&P 500 as of November 11, 2009—14—is consistent with long-term earnings growth of 5 percent.8 This assessment is more reasonable, considering that long-term earnings growth for the market as a whole is unlikely to differ significantly from growth in GDP,9 as prior McKinsey research has shown.10 Executives … ought to base their strategic decisions on what they see happening in their industries rather than respond to the pressures of forecasts, since even the market doesn’t expect them to do so.

About the Authors

Marc Goedhart is a consultant in McKinsey’s Amsterdam office; Rishi Raj and Abhishek Saxena are consultants in the Delhi office.


1 Marc H. Goedhart, Brendan Russell, and Zane D. Williams, “Prophets and profits,”, October 2001.

2 US Securities and Exchange Commission (SEC) Regulation Fair Disclosure (FD), passed in 2000, prohibits the selective disclosure of material information to some people but not others. The Sarbanes–Oxley Act of 2002 includes provisions specifically intended to help restore investor confidence in the reporting of securities’ analysts, including a code of conduct for them and a requirement to disclose knowable conflicts of interest. The Global Settlement of 2003 between regulators and ten of the largest US investment firms aimed to prevent conflicts of interest between their analyst and investment businesses.

3 The correlation between the absolute size of the error in forecast earnings growth (S&P 500) and GDP growth is –0.55.

4 Our analysis of the distribution of five-year earnings growth (as of March 2005) suggests that analysts forecast growth of more than 10 percent for 70 percent of S&P 500 companies.

5 Except 1998–2001, when the growth outlook became excessively optimistic.

6 We also analyzed trends for three-year earnings-growth estimates based on year-on-year earnings estimates provided by the analysts, where the sample size of analysts’ coverage is bigger. Our conclusions on the trend and the gap vis-Ă -vis actual earnings growth does not change.

7 Market-weighted and forward-looking earnings-per-share (EPS) estimate for 2010.

8 Assuming a return on equity (ROE) of 13.5 percent (the long-term historical average) and a cost of equity of 9.5 percent—the long-term real cost of equity (7 percent) and inflation (2.5 percent).

9 Real GDP has averaged 3 to 4 percent over past seven or eight decades, which would indeed be consistent with nominal growth of 5 to 7 percent given current inflation of 2 to 3 percent.

10 Timothy Koller and Zane D. Williams, “What happened to the bull market?”, November 2001.