Wall Street Analysts Too Upbeat on IPO Earnings, Study Finds

Wall Street analysts routinely issue overly rosy earnings outlooks for companies their firms are taking public, leaving stock prices to flounder when forecasts don’t pan out, according to a study released Friday.

That’s because those too-optimistic, long-term estimates for earnings growth most often result in inflated offering prices, according to the study by researchers at Harvard Business School and the University of Pennsylvania’s Wharton School.

The researchers found that analysts exhibit even more optimism in their earnings forecasts when they are employed by the lead underwriter of a particular equity offering.

“Beware of the relationships,” Patricia Dechow, one of the study’s authors, said in an interview.

The findings help explain the long-run under-performance of stock prices in the years that follow equity offerings, the researchers said. Of course, by that time companies usually have raised the funds they need and Wall Street has probably already made its money on the deals. But small investors can get caught in the middle.

For starters, prices are likely to reach inflated levels when stocks start trading publicly, Dechow said.

When earnings don’t measure up to forecasts, the stocks can tumble by as much 20% to 30% in the first five years after offerings, she said. Some stocks fare even worse if forecasts call for extremely strong earnings growth.

“If you’re a small investor, just keep away from these initial public offerings. Don’t invest in these things for the first couple of years,” said Dechow, an assistant accounting professor at Wharton.

Publicity surrounding the initial offerings of equity in well-known companies often attracts attention from investors seeking to dabble in the stock market. But caution is advised.

“Stay away from it, if it’s being hyped,” said Manish Shah, publisher of IPO Maven. “If you’re patient enough to wait, you can buy some of these companies at a very reasonable price--they do go through a down cycle.”

The study found that even unaffiliated analysts jump on the bandwagon, betting that analysts working for the underwriters have based their strong earnings forecasts on extensive research and access to company executives.

Apparently, no one wants to get a reputation for being a hard-nose, either. Concern about chasing away future underwriting business may also influence their forecasts, the researchers said.

The study focused on more than 7,000 analysts’ long-term earnings forecasts for those stocks. It looked at nearly 1,200 common stock offerings made between 1981 and 1990 so that it could track at least five years of earnings results.

“Our results suggest that affiliated analysts play an important role in raising new equity capital at lower cost by convincing investors that the issuing [companies] have overly optimistic long-term earnings prospects,” the study said.

The other authors of the study were Richard Sloan of Wharton and Amy Sweeney of Harvard.