Target Price Optimism, Investor Sentiment, and the Informativeness of Target Prices

Abstract

This paper provides large sample evidence that financial analysts’ target prices are more informative in periods of low investor sentiment compared to high sentiment. While prior research argues that target prices have differential investment value depending on analysts’ use of sophisticated or heuristic valuation models, we find that these differences are largely explained by investor sentiment. We find that the investment value of target prices based on both sophisticated and heuristic valuation models is close to zero in periods of high sen- timent. Return predictability is highest for target prices based on sophisticated valuation models during periods of low sentiment, but only slightly higher than for heuristics. Also, target price errors are lower for low sentiment. In periods of low sentiment, when concurrent market prices are below intrinsic values and target prices are above market prices due to analysts’ optimism, target prices are more reflective of intrinsic values and hence more informative. In addition, we find that investors do not understand the differential informativeness of target prices. Market reactions to target price revisions do not reflect the higher informativeness in low sentiment. Rather, investors overreact to target price revisions in high sentiment, potentially fueling the build-up of bubbles.