Research and Development Expense and Analyst Forecast Errors: An Underestimation of Sales or Overestimation of Expenses?

Abstract

We test whether analysts adequately incorporate the implications of research and development (R&D) activities into their forecasts by observing the relation between R&D expense and future forecast errors for earnings, sales, and expenses. We find that analysts systematically underestimate the future earnings implications of R&D, and that this underestimation of earnings is attributable to an overestimation of future expenses rather than an underestimation of future sales. We further find that our results are driven by firms with high fixed costs and high sales growth, which suggests that analysts, on average, assume that costs vary proportionally with sales in high R&D firms perhaps due to the difficulties in separating fixed and variable costs in most financial statements.