Should you trust the market predictions of financial analysts? In a recent interview for National Public Radio’s Marketplace Money report, Rick Mendenhall, finance professor at the Mendoza College of Business, discussed how analysts arrive at their earnings predictions and the reaction of stock prices to earnings reports.
Mendenhall studies stock market anomalies and recently was named as chair of the Finance Department at Mendoza.
NPR Reporter Alisa Roth asked Mendenhall if analysts just make up predictions, citing recent first-quarter earnings of companies including Coca-Cola and Target, which handily beat expectations.
“Different analysts do things differently,” said Mendenhall. “Mostly, they are doing what we call pro-forma financial statements, so they are starting with the sales or revenue prediction. They’re just building an income statement from there and they come up with a forecast for earnings.”
He went on to say that if the analysts predict a company will see a dollar of earnings and the actual amount is 80 cents, the price of the stock will go down. The reason for the drop has more to do with disappointing the expectations of investors than company performance. So companies try to manage analysts’ expectations to avoid the disappointments – and the declines.
Mendenhall also said for individual investors, a stock’s past performance is a poor guide to predicting future earnings.
In an additional explanation provided after the interview, he added, “Most investors should focus on asset allocation – diversifying across asset classes such as stocks, bonds and possibly real estate – and keeping costs low, including taxes. The latter is best accomplished by using index funds or exchange traded funds (ETFs) that just try to match indexes such as the Standard & Poor’s 500. Some managers will beat market averages, but it is very difficult to predict in advance which ones.”
To listen to the NPR story, “Great Expectations,” visit: http://marketplace.publicradio.org/display/web/2008/05/09/great_expectations/