The Impact of Analyst Industry Expertise on Market Prices

Abstract

Security analysts are often considered experts in the industries they follow. We analyze the impact of such expertise on market prices and returns in a setting where firms’ earnings components may differ in their levels of persistence over time. In this context we show that a firm’s post-earnings announcement price is a function of the analyst’s prior earnings forecast even though that forecast does not contain any incremental information about current period earnings. This is because the forecast provides information about the firm’s individual earnings components, which is useful in predicting its future earnings. We demonstrate how this result can serve as a theoretical underpinning for the observed market premium earned by firms that meet or beat consensus analyst forecasts and how it can explain the premium’s empirical link to future earnings performance. This result also provides a rational justification for the practice of expectations management. We derive the optimal expectations management strategy in our setting and compare its effectiveness to that of earnings management.