The Accuracy of Andy& Forecasts

of Earnings per Share

Russell M. Barefield, University of Arizona

I Eugene E. Comiskey, Par-due University
I

The past several years have witnessed a surge of interest in the topic
of earnings forecasts, with recent stud:ies exploring a variety of charac-
teristics of such forecasts made by management [2,3,5,7]; these
characteristics include forecasting per rmance in relation to length
of forecast interval, industry classification, and company size, In addi-
tion, management forecasting performance has been compared to that
achieved through application of a number of mechanical forecasting
procedures [3]. F ar 1ess attention has been given to earnings forecasts
made by security. analysts [4, 83.
This article reports on a study of analyst forecasta for a lOO-
company sample of New York Stock Exchange companiee,. Forecasting
performance is analyzed in terms of year and industry membership,
and in relation to a naive mechanical forecasting rule which assumes
that earnings in year T equal tihose in T-l. In addition, the performance
of analysts in forecasting “turning points” in an earnings series is
studied.
Analyst forecasting performance proves to be comparable to that
of management on several dimensions. Industry membership appears
to have a strong influence on forecast errors; forecast errors are
associated with historic earnings variability as well as with the market-
beta measure of risk. Also, analysts appear to achieve some success h
forecasting turning points in an earnings series.

The Sample
The only readily accessible source of extensive foreoasts is the Standard
and Poor’s Earnings .rFbrecaster (El?),’ which is published biweekly
and contains current forecasts of earnings per share for more than
a thousand leading corporatisne. The forecasts are provided by
 242 of Business Remdi
Journal

keragc h@uses and other Wall Street researchers and analysts. The
number of forecasts per company varies considerably and, in general,
is a positive function of the size and investment interest of the
company. Two or three forecasts per company seems to be the norm,
with a few companies having as many as 10 forecasts. While these
do not represent management forecasts, per se, it seems probable
that management’s own public and private forecasts would have been
a key input into the analysts’ projections.
The IOO-company sample used in this study was drawn from the
EF and included only companies satisfying three constraints: (1) a
December 31 year-end; (2) listing on the New York Stock Exchange;
and, (3) inclusion in the EF each year during the period, 1967 to
1972 (see the appendix for a list of the sample companies) .2
Attention was directed to December 31 companies in order to
reduce the problems associated both with securing the necessary
volumes of the EF and with obtaining uniformity of forecast-interval
length across all companies in the sample; this constraint could have
introduced a bias of unknown nature since it precluded representation
from rompanies in industries typically having other than December
31 year-ends-e+, retailers. New York Stock Exchane listing
insured full availability of financial data where additional informa-
tion was required on such items as extraordinary gains and losses,
stock split! and dividends, fully diluted earnings, etc.; while uniformity
and data-analysis requirements necessitated forecast availability for the
full 1967-72 period ( 1%7 beiiag the first year the EF was published).
(Zen the six-year period arL sample of PO0 companies, the basic
data bank developed for the study consisted of 600 earnings forecasts.

Mecresurementof Forecast Error

Forecast,errors were developed from earnings estimates made approxi-

’ mately 10 months (the forecast interval) prior to the end of the
accounting period. Forecast error is defined as the absolute value
of the percentage difference between actual and forecasted earnings:

(1) FE = IF - Al/F

where, F = earnings forecast per share (EPS) ; and,

A = actual EPS.

The average forecast error over the six-year period also was
calculated for each company:

1 6
(2) iZ=G I3 IF, - A,f,‘F, .
I=1
Accuracy of Analysts’ Forecasts 243

The mean absolute error measure implicitly assumes an indiffer-

ence to the error direction. Moreover, loss associated y&h the error
is proportional to its size. Use of a mean squared erzur would be
consistent with a loss function which increases rnci:.e than propor-
tionately with the error’s magnitude. Since little is known ahout the
nature of the loss function associated with earnings forecast errors,
the mean absolute error measure has been selected due to its simplicity
and also to its uBe in previous studies of earnings forecast errors.
Most frequently, primary EPS before extraordinary items is the
forecasted earnings measure repclrted in &e EF. Understandably,
analysts do not attempt to include extraordinary items in building
their forecasts. Furthermore, where ,a designation is provided, the
usual forecast is of prinuzry EPS. In some cases forecasts of both
primary and fully diluted EPS are provided. In the present study,
where only fully diluted forecasts were provided for a company,
care was taken to insure that calculation of the forecast error was
based upon actual EPS on a fully dilated basis. In addition, forecasts
were adjusted for stock splits and stock dividends before calculation
of the forecast error.
Since there usually was more than a single forecast for each
company in the EF, each year’s forecasted EPS was defined as the
simple average of the forecasts provided. ‘ro illustrate both this and
other important computations, an examination of the dlata-found in
Table l-for one of the sample companies follows.
The 196’7 forecasted EPS in Table 1 is an average of the analyst
forecasts appearing in the EF (a single issue) for the salmple company.
Two forecast error measures are calculated: ( 1) the annual forecast
error-e.g., 6.70 in 1%7 and 6.67 in 1%; and, (2) the average
forecast error for the six-year period-e.g., 5.27 for the sample
company. Note that, from the definition of FE in (2), the mean
of the absolute values of the percentage forecast errors is taken, and
not their algebraic sum.
An additional error concept involves the failure to correctly predict
Table I: Forecasted and Actual EPS Data *

Fcmecas t
Forecasted Actual .Error
Year EPS EPS 0%

1967 $1.79 $1.91 6.70

1968 2.10 L96 6.67
1969 2.06 2.08 0.97
1970 2.10 2.32 10.48
1971 2.50 2.62 4.80
1972 2.97 3.03 2.02
244 Jownd of Business Research

turning points in the earnings, series. For example, assume the fol-
lowing series of forecast and ectb.ml changes in ea;zGngs (only the
sign of each change is given): forecast, +++; actual, ++-. A
single turning-point error is found in the failure to forecast the turning
point in the third year of the series. Other possible turning-point rela-
tionships will be discussed when an analysis of turning-point errors is
presented in a later section.
AnalyGs of the Forecasts: Awerage Forecast Errors
ltnforma tion concerning the relationship between actual and forecasted
EPS for each year (1967-72) and for the total period is presented
in Table 2.
The data in Table 2 reveal, with the exception of 1972, a persistent
optimistic bias in the analyst forecasts, with forecasted EPS exceeding
actual EPS in approximately 64 percent of the total. These results
are identical to those of the MacDonald study [7: 509] of management
forecasts, in which 64 percent of 201 forecasts exceeded the actual EPS.

Z’ubk 2: Forecasted and Actual EPS Relationships, 1967 to 1972

Number of Forecasts
Forecasted/Actual
Relationship 1967 1968 1969 1970 1971 1972 1967-72
.

Forecasted EPS exceeds

actual 68 67 68 75 61 43 382

Forecasted EPS is less

than actual 31 32 31 23 36 54 207

Forecasted EPS eqwls

actual 1 1 1 2 3 3 11

Table 3 contains the average forecast errors by year for the 100
companies. The 1970 forecast error reflects an apparent inability to
predict either the general economic downturn of 1970 or its impact
on corporate earnings, The forecast errors reported here are similar to
those reported in the limited study of analyst forecasts by the Financial
Analysts Federation, which indicated that “An earnings forecast for
the ‘average’ firm made twelve months prior to the year end tends to
deviate . . . by about 10 to 15 percent” [9: 791.
Forecast errors in studies of mwement forecasts are difficult
to compare with those in Table 3 due to differences both in the
sample and in the forecast interval. For example, a study by Copeland
and Marioni [3] included numerous forecasts made after more than
one=quarter of the fiscal year had elapsed; with this limitation in
mind, their study showed an average forecast error-ignoring signs-
of 20 percent for a 49-company sample for 1968. Other studies of
mauagement forecasts have produced similar results--e.g., [ 71.
 Accwacy s/ AM~~TS’ Forecasts 24!5

Table 3: Average Forecast Errors, 1%7 to 1972

Average Forecast
Error
Year w

1967 14*14
I968 13.92
1969 13”31
19.70 22.59
1971 18.26
1972 14.22
1967-72 16.07

The distribution of average forecast ,crrors by industry classifica-

tion, for the entire 1967-72 period, is presented in Table 4. These
data cannot be interpreted as definitive estimates of average forecast
errors by industry due to problems associated with categorization of
the companies as well as with the limited number of companies in
several of the industry categories. They do, however, tend to conform
fairly well with a similar classification of management forecast errors
by MacDonald [“I: 510).

TabEe 4: Average Forecast Errors by Industry, 1967 to 1972

Forecast Coefficient
Industry Number Error B of Variation
Utilities 15 4.49 .72 .0474
Banking 3 6.05 .9? _064E
Drugs 3 7.71 1.08 .1108
Food/Beverage/Tobacco 8 8.45 .90 . f055
Other 6 10.79 1.16 -1052
Chemical 4 15.29 1.15 .1369
Oil 6 19.93 1.06 .15x
Manufacturing/Industrial 48 19.98 1.12 .2869
Transportation 7 32.96 1.08 -4032

Weighted Averages lCIC 16.07 3.03 .2Q;r5

Also included in Table 4 are average market betas and coefficients

of variation (standard error about a linear trend line divided by t.h?
mean value of 1967.72 EPS) by industry. The% data support the
position of the Financial Analysts Ft&ra&rr .;uGy indicating a posi-
tive relationship between forecast errors and beta 19: 801. Further-
more, the forecast-error and coefficient-of-variation relationships sug-
!/
gest, not surprisingly, that a more volatile earnings stream generally
is more difficult to predict.
2445 Journd of Business Reseurch

AmalyGs of the Forecasts: Turning-Point Predictions

In addition to average forecast errors, the ability of analysts
- to predict
turning points in an earnings series is of interest. Given the positive
autocorrelation in series such as earnings, Zarnowitz [12: 511 argues
“that it should be rather easy to predict a continuation of the
rise or fall in these series; to forecast correctly the end of the current
movement or phase appears to mark a more meaningful predictive
success.”
A dichotomy for evaluating turning-point forecasting [lo: 291
is given in Table 5, along with the turning-point data from the present

Table 5 : Turning-Point Predictions

Predicted
Turning Na turning
Actual point point

Turning point (i) 132 (iii) 67

No turning point (ii.3 37 (iv) 164

study. Cells (ii) and (iii) represent the two types of turning-point
errors: forecasting a turning point that does not materialize (ii),
or failing to forecast a turning point that does develop (iii). The num-
bcr of correct forecasts is the sum of cells (i) and (iv), 296 from a
total of 400.” I n regard 10 the matter of turning-point prediction, some
writers have held that ‘%nalysts are consistently superior to (mechan-
ical) models. . . .” [9: 801. While no comparable data are available
with which to compare the results of the present study, the “turning
point” performance of analysts appears to be relatively good; the
analyst forc*asts predicted 132 from a total of 1.99 turning points-
i.e., approximately 66 percent.’
Average percentage fi3recast errors and turning-point errors pro-
vide a partial descr+tio81 of analysts’ earnings predictions. !knalyst
performance against a uaive no-change extrapolation model next is
examined.

Relative Analyst Perjwmance: The Naive Model

One approach to an analysis of forecasting performance is to compare
the analysts’ forecast reollts with those which would be produced with
the use of a naive mechanical forecasting model. A fairly simple test
based upon this concept has been developed by Theil [ 11). The test
involves computation of a.n “inequality coefficient” (U) for each
of the series of company-forecast and actual EPS data, with U
defined as:
Accuracy of Analysts Forecasts 247

[ SI (Pi - A,)” 1”
(3) U = ?I1
[ 2 Ai” J”
i:=I
where, A,, P, = pairs of predicted (P,) and actual (A,) changes.
U reaches “0” as a lower boundary when all predictions are cor-
rect--i.e., when Pi = A,; U assumes a value of “1” when the fore-
casting method results in the same performance (measured by standard
error) as a naive forecast of “no change” for each period; U exceeds
“1” when the forecasting procedu.re is less effective than the naive
no-change benchmark.
The U value s f or all companies in the sample are included in @e
appendix; the distribution of U values’ is given in Table 6. The U
values reveal that the forecasts for 68 of the 100 companies were
more accurate-i.e., U 1ess than l-than those which would result
from use of a naive no-change extrapolation. (Another mechanical
model which could have been used for comparative purposes involves
predictions based upon extrapolations from a linear trend fitted to the
EPS series. It seems quite certain that the analysts* performance would
compare less favorably with such a standard in terms of percentage
forecast errors; however, such a model would not predict turning
points, which the analysts did predict with ‘some success.)

T&e 6: Distribution of Theil Inequality Coefficients

U Value Nmber of Companies

o- .25 9
.26 - .5O 22
.!i1 - .75 19
.76 - .99 18
1.00 - 1.25 16
1.26 - 1.50 4
>I..50 12

Total 100

Forecast Error Determinants

None of the preceding discussion identifies specific reasons for large
forecasting errors. One possibility, of course, is that analysts USA
simple linear extrapolation models; this position is ccontradicted,
however, by their success in predicting turning points. As a practical
matter, little is known about analysts’ forecasting procedures and
hence it is difficult to attribute error levels to forecasting nrerhodology.
 -
Journul of Business Resewch

Therefore, attention next is focused on a priori error determinants

plus factors discernible from corporate annual reports.
,4 key factor in forecast error determination is a firm’s cost
structurethat is, the relative proportion of fixed and variable costs.
Errors in forecasts of sales produce magnific:d differences between
actual and forecasted EPS based upon the proportion of fixed and
variable costs in a firm’s cost structure. These relationships can be
illustrated as ;
(4) Jr - JdF = (S - S,) (P - V) - F
where, nd, aF = actual and forecasted earnings;
s, s, = actual and forecasted unit sales;
P= unit price;
v= unit variable cost; and,
F= total fixed expense.
By inspection it can be seen that, as V becomes smaller (a higher
proportion of fixed to variable costs), sales forecasting errors produce
a greater difference between actual and forecasted earnings.
Other forecast error determinants were identified by reviewing the
annual reports of sample companies which had forecast errors of at
least 25 percent or twice the average for their industry. It seemed
reasonable to expect management discussion of unusual performance
in cases involving large forecasting errors, even though such forecasts
were not made by management per se. This assumption was borne out
in nearly all cases; that is, large analyst-forecasting errors were
accompanied by annual report commentary-normally in the presi-
dent’s letter or review of operations-explaining the unusual per-
forma;ice.
Explanations accompanying large forecasting errors identified a
wide range of factors. The error determinants cited by management-
when grouped into the categories established by Gillis [6: 741 in
his review of the legal aspects of forecasts-involved: ( 1) general
and economic assumptions; (2) industry assumptions; and, (3) in-
dividual company assumptions. The results are given below.
General : increased foreign competition
general economic turndown
government spending cutbacks
monetary policy
foreign govemment’al policy changes
Industry: strikes
wage settlements
price weakness Idue to excess industry capacity
increased costs of industry’s raw materials
Accurtwy of Xadysts' Forecasts 249

Company: strikes
wage settlements
start-up or break-in problems with new products or
processes
overestimation of new product demand
cost overruns
construction delays
The error determinants which seemed to appear with greatest
frequency were “strikes” and “start-up or break-in problems with new
products or processes.” Whereas it may not be feasible to forecast or
adequately incorporate many of these factors, they do represent error
determinants which deserve the carrfful attention of either manage-
ment or security analysts in their efforts to forecast EPS.

Summary and Conclusions

This study has attempted to enhance the limited information available
on the earnings forecasting performance of analysts. The investigation
of earnings foreczists for 100 companies revealed a bias toward
overestimation of actual earnings performance-i.e., forecasted earn-
ings exceeded actual earnings in approximately 64 percent of the
cases. Average forecast errors, ignoring signs, appeared comparable
to those reported for other studies of b,oth management and analyst
forecasts.
Turning-point prediction seemed to be the analysts’ forte, having
accurately predicted 132 of a total 197 turning points for the sample.
Measured against a naive no-change model employing t%s Theil in-
equality coefficient, analyst forecasts bettered the naive model for
68 of the 100 companies. However, the naive no-change model prob-
ably is a weak standard of comparison; hence, analyst forecasting per-
formance might decline if matched against more sophisticated, yet
mechanical, forecasting models.
Aside from defects in forecasting methodology, which were not
considered in the present study, the determinants of forecast errors in-
cluded a range of both endogeneous and exogeneous factors which
were either unpredictable or inadequately incorporated into analysts’
earnings forecasts.
As noted at the outset, little research effort has been directed to
the study of either the nature or the role of analysts’ forecasts of EPS,
although such forecasts would seem to be a key element in the form-
ulation of investment decisions. Additional research efforts could
focus on a variety of issues related to earnings forecasts, such as:
(1) the methodology empIoyed by analysts in forecasting EPS; (2)
the role of EPS forecasts in investment decisions and security price
formation; (3) the comparison of afialysts’ forecasting perfonnaince
250 Jownul of Business Research

with that of management and of a wider range of mechanical forecast-

ing models; and, (4) the determinants of forecast errors.
!n regard to analyst performance as compared with mechanical
forecasting models, the costs versus benefits of additional forecasting
accuracy becomes an obvious issue. Generally, analysts outpredict the
naive no-change model. This forecasting accuracy results in costs
which, in turn, probably are borne by the investor. The expenditure
of still greater amounts on forecasting perhaps would produce more
accurate forecasts. A useful question for research concerns how such
cost/benefit trade-offs should be evaluated from the viewpoint of both
the individual investor and the market as a whole.

Appendixt The Sample Companies

Theil U Theil
1. AC’.: Industries .85 51. Interstate Pov~-z .92
2. Abbott Labs .55 52. ITEK .20
3. Ah0 1.93 53. Johns-Manville .38
4. Allied Chemical .74 54. Kaiser Cement and Gypsum 1.02
5. American Airlines 7.71 55. Kerr -McGee .25
6. American Electric Power -41 56. Koppers .77
7. American Seating .76 57. Liggett and Myers .61
a. Apco Oil -91 58. Louisiana Iand and Exploration 1.25
9. Arizona Public Service .41 59. Magnavox 1.07
Associated Transport 2.29 60. Marquette Cement 1.21
::: Babcock and Wilcox .97 61. Maytag .38
12. Bausch and Lomb .QO 62. Medusa Portland Cement .61
13. Baxter Labs .35 63. Missouri Pacific Railroad .65
14. Bell and Howell 1.23 64. Montana Dakota Utilities .58
15. Boston Edison 2.23 65. Morse Shoe 1.25
16. Brunswick .40 66. tirphy, G. C. 2.47
17. BUdd .49 67. National Can .27
18. C.I.T. Financial .33 New England Electric .63
19. Carborundum .76 :t : Norfolk and Western Railroad 1.67
20. Central and Southwest .52 70. Northwest Airlines 1.90
21. Charter N.Y. 1.31 71. Oklahoma Gas 8 Electric .64
22. Cities Service 1.53 72. PPG Industries .60
23. Cluett Peabody 1.10 73. Pepsico .18
24. Colt Industries 1.30 74. Pitney-Bowes 1.30
25. Combustion Engineering .46 75. Public Service of Colorado .48
26. Continental Oil .34 76. Raytheon .37
27. Corning Glass Works .75 77. Bobertshaw Controls .74
28. Cox Broadcasting .38 78. Royal Crown Cola .55
29. Cumnins Engine .35 79. Safeway Stores .78
30. Dayton Eower and Light 1.95 80. Schlitz Brewing -14
31. DelMarVa Power .85 81. Searle, G. 0. .58
32. Dr. Pepper .07 82. Signal Companies .81
33. Dow Chemical 1.04 83. South Carolina Electric 8 Gas 1.00
34. Eastern Gas 8 Fuel 1.03 84. Square D .78
35. 8mery Air Freight .53 85. Studebaker-Worthington 1.07
36. FMC .a3 86. Superior Oil 1.35
37. ‘P’eZeral Mogul .RO 87. Texas Gas Transmission .89
38. First National City .lQ 88. Times Mirror .41
39. Flinktkote .41 89. Union Camp .60
40. Foster Wheeler 1.18 90. United Aircraft .71
41. General Cable 1.68 91. U.S. Gypsum 1.20
42. General Electric .78 02. U.S. Tobacco .ll
43. Grolier 1.07 93 . Vulcan Materials .73
44. Gulf Oil .72 94. Warner Lambert .32
45. Hawaiian Electric .71 95. Washington Water Power .G6
46. Hershey Foods .95 96. We11s Fargo .2a
47. Honeywell .81 Q7. Wesco Financial 1.09
48. Howard Johnson .42 98. h-yerhaeuser 1.25
49. Illinois Central Industries 2.03 99. Witco Chemical .85
59. IBM .35 100. Youngstown Steel Door 2.50
Accuracy of Analysti’ Forect~~ 251

Footrr;otes

IAppreciation is expressed to Joseph M. Gallagher, Vice President of Standamd and

Poor’8 Corporation, for making copies of the Earnings Forecaster available to the
authors.
Gubject to these requirements, the sample was drawn in a random fashio?.
Whough the data base is 600 forecasts, two yeare of performance (20~ forecasts)
is given up in establishing the direction of a trend.
4Copeland and Marioni, in their study of management forecasts [3: 4993, found
that only 14 percent oi the management forecasts failed to predict the direction earnings
would take; however, their d&z consisted of only 50 predictions and their selection
procedure may have been biased in terms of representation by superior management
forecasters.
252 joumul of ~Business Remwch

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