An Additional Source of Financial Analysts' Earnings Forecast Errors: Imperfect Adjustments for Cost Behavior

Abstract

We test a hypothesis that financial analysts use a simple algorithm of an equal growth rate for expenses as is for sales when they forecast corporate earnings by examining the errors in analysts' earnings forecasts. If expenses change at a lower rate than sales in absolute terms due to the fixed portion of expenses, then analysts' forecasted expenses will be higher (lower) than actual when they forecast an increase (decrease) in sales, resulting in lower (higher) forecasted than actual earnings assuming that analysts have perfect sales forecasts. Using 3,220 individual financial analysts' sales and earnings forecasts during the period of 1996–2005 for which sales forecast errors are close to zero, we find that the errors in analysts' earnings forecasts are positively related to their expected sales growth rate. This result is consistent with the hypothesis that analysts' imperfect adjustments of cost behavior result in systematic errors in their earnings forecasts.