Do Analysts Influence Corporate Financing and Investment?
Doukas, John A., Kim, Chansog "Francis", Pantzalis, Christos, Financial Management
We examine whether abnormal analyst coverage influences the external financing and investment decisions of the firm. Controlling for self-selection bias in analysts' excessive coverage, we find that firms with high (low) analyst coverage consistently engage in higher (lower) external financing than do their industry peers of similar size. Our evidence also demonstrates that firms with excessive analyst coverage overinvest and realize lower future returns than do firms with low analyst coverage. Our findings are consistent with the hypothesis that analysts favor the coverage of firms that have the potential to engage in profitable investment-banking business.
We do not want to maximize the price at which Berkshire shares trade. We wish instead for them to trade in a narrow range centered at intrinsic value ... [We] are bothered as much by significant overvaluation as significant undervaluation. Warren Buffet, Berkshire Hathaway Annual Report, 1998.
One of the distinct characteristics of the US capital market is its transparency. Unlike capital markets in other countries, companies traded on the US stock markets are supposed to accurately report a wide range of information to investors, who then use that information to assess the risks and rewards of their investments. Security analysts generally receive credit for contributing to the stock market's transparency. In response to the growing demand by investors and corporate managers for the dissemination of firm-specific information and stock valuation, security analysis has increased considerably in recent years. In the 1990s, stock recommendations and earnings forecasts issued by analysts associated with major brokerage houses gained dramatic prominence among investors and corporate managers, and came to represent a primary source of information for investors.
In this paper, we study whether security analysts play an important role in corporate finance. We ask whether heightened analyst coverage is associated with excessive external financing and overinvestment. The pressures and economic incentives to generate trading commissions and investment-banking business can influence corporate financing, and as a result, investment, when analysts focus on serving these interests at the expense of the integrity of their research. An empirical investigation of the role of analysts from this perspective is important for the understanding of financial markets' capital allocation process.
Despite the potentially useful role of security analysts, the recent revelations of accounting fraud at major companies such as Enron and WorldCom, among others, have severely shaken investor confidence in the US stock markets. As a result, concerns about the role of analysts have increased. Subsequent to the Nasdaq crash of 2000, security analysts have come under considerable criticism. Declining standards and quality of research have been mentioned, but the most frequently cited criticism is that economic incentives motivate analysts to direct their attention and stock recommendations toward stocks that generate investment-banking business and trading commissions. (1)
Investment-banking considerations and trading profits could also explain analysts' influence on corporate managers' behavior in recent years. Jensen (2004, 2005) argues that in trying to conform to analysts' pressures for growth rates that are essentially impossible to achieve, corporate managers often revise plans and budgets to meet analysts' expectations. In some cases, managers--fearing the consequences of missing analysts' expectations--will shape the capital budgeting process around analysts' consensus earnings forecasts. Enron, Cisco, and Nortel, among others, are recent examples of firms whose managers' corporate actions were (or are, as the case may be) designed to sustain overvalued stock shares by pursuing corporate strategies that reflect analysts' pressure for higher growth targets. …