Advisory services are provided by financial (or securities) analysts, among others. Financial analysts collect and analyse different sources of financial information and help investors decide where and when to invest by analysing past management decisions and generating expectations about future developments.
Financial analysts without a magic ball
To provide investment advice and issue stock recommendations, financial analysts compile and interpret information from various sources, primarily related to a firm's market position and financial performance. In our work in Review of Accounting Studies, my co-author Marco Mattei and I examine how product market competition affects analysts' forecasts.
Investment recommendations are high-quality when financial analysts accurately forecast future developments in product markets and their impact on firm performance (usually proxied by earnings per share).
|How can information help businesses?|
Collecting and processing of information is important for all business decisions, including capital allocation on financial markets. Information can make corporate projects real by attracting financial support for investment in new facilities, technology and human capital. Information can also enable some market participants to make gains at the expense of others who receive and use information with a time lag.
Our findings reveal that analysts' forecasts are less accurate when firms face greater competitive pressure. Competitive pressure makes future performance less certain; furthermore, it adversely affects the quality of the financial information. As a result, financial analysts are unable to accurately forecast how firms facing greater product market competition will perform, thus producing less accurate expectations, i.e., earnings-per-share forecasts.
Our findings reveal that analysts' forecasts are less accurate when firms face greater competitive pressure
How does product market competition affect financial analysts?
Intense competition leads to more dynamic product markets and increases the uncertainty of market outcomes for each player. As a result, competitive threats present a challenge for financial analysts in forecasting earnings. We suggest that more competitive markets also adversely affect the quality of information used by investors.
We argue that typically used measures of competition (such as industry concentration) are imperfect and use a text-based measure of competitive pressure (product fluidity).
Our analysis shows that firms facing competitive pressure are likely to:
- Contain management assumptions, which are more difficult to foresee (i.e., accruals quality is lower).
- Request that sensitive (proprietary) information to be withheld by the securities authorities (i.e., Securities and Exchange Commission).
- Stop revealing management expectations about future developments and financial results to other parties in the form of management guidance.
- Hide the identity of their major clients.
As a consequence, financial analysts may not only have diverging opinions about future market developments in the presence of intense product competition; furthermore, they may also have less and noisier information to base their forecasts on.
How can this research help managers and investors?
Managers facing greater competition often prefer to withhold information because of concerns that "competitors can copy our strategic moves, thus erasing our competitive advantage."
Keeping competitors in the dark, however, has important implications. When less and noisier information is provided, financial analysts are likely to issue less precise forecasts. As a consequence, financing projects may become more difficult and/or more expensive.
Firms operating in more competitive markets will have, on average, less precise and more diverging forecasts issued by financial analysts. Before following a piece of investment advice or an analyst's recommendation, it would be beneficial to consider product market dynamics.
If a firm's product market is more competitive, further analysis is required in order to determine whose forecasts are more precise (for instance, close investigation of analysts' ranking position and their accuracy in the past).
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