Valuation Implications of Accounting Conservatism

Abstract

This paper examines whether financial analysts understand the valuation implications of unconditional accounting conservatism when forecasting target prices. While accounting conservatism has a downward effect on reported earnings, it does not have a downward effect on the present value of future cash flows. We examine whether analysts add back the effect of accounting conservatism incorporated in their own earnings forecasts when using these forecasts to estimate target prices. We find that signed target price forecast errors (actual minus forecast) have a significant positive association with the degree of conservatism in earnings, suggesting that on average target prices are biased due to the effect of accounting conservatism. Cross-sectional analysis suggests that more sophisticated analysts undo the effect of conservatism to a greater extent than other analysts, although their target price forecasts also exhibit systematic bias due to conservatism. In additional analyses, we track the analyst's valuation path to understand the mechanism through which unconditional conservatism leads to bias in target prices. We first establish that analysts' earnings forecasts do incorporate the downward effect of accounting conservatism. Based on alternative earnings-based valuation models/heuristics that analysts may use, e.g., the forward P/E and the PEG ratio, we find that analysts fail to add back the effect of accounting conservatism incorporated in their earnings forecasts when deriving their target prices. As a consequence, we find that, for extreme levels of conservatism, the bias in analysts' target prices due to conservatism leads to a distortion of market prices. The evidence highlights the concern that the use of simple valuation heuristics by analysts can inhibit price discovery, especially in the presence of conservative accounting.