Valuation Bias and Limits to Nudges

Abstract

Because of limits to arbitrage, it is reasonable for sell-side analysts’ target prices to deviate from their corresponding estimates of future fundamental value. Although this inequality does not imply that sell-side analysts should provide biased estimates of fundamental value, many do. According to the author, a key contributor to this bias is making an unwarranted assumption that in the long run firms can be expected to earn more than their cost of capital. Biased estimates of fundamental value can harm long-term investors. At the same time, the author explains in this article that there are simple nudges that can help avoid the bias. Nevertheless, limits to nudges associated with buy-side catering prevent their application. The magnitude of the associated bias can be substantial for the stocks of large firms that dominate the market. Notably, sell-side analysts’ upwardly biased estimated fundamental values for these stocks lie in the vicinity of consensus target prices and market prices. According to the author, this suggests that valuation bias associated with stocks of large firms that dominate the market is consistent with intermittent overvaluation of these stocks and the overall market. TOPICS:Fundamental equity analysis, portfolio management/multi-asset allocation