Analysts’ Target Prices and Stock Recommendations

Abstract

In this study, I propose a simple framework to examine the link between analysts’ target prices and their stock recommendations. I hypothesize that the favorableness of stock recommendations is positively associated with the deviation of the ratio of target price to price from the benchmark return. I employ three widely used models to proxy for the benchmark return: the CAPM, Fama and French (1993) 3-Factor Model and Carhart (1997) 4-Factor Model. I find results consistent with my hypothesis. Both contingency table and regression analysis support the prediction that analysts issue more favorable recommendations to stocks with a higher difference between the ratio of target price to price and the benchmark return. I further investigate whether this positive association is due to analysts’ perception about risk or mispricing. I use firm characteristics as the explanatory variables to examine how analysts incorporate them into their outputs. I find evidence that target prices are associated with growth variables the same way as recommendations are. However, I am not able to completely rule out the risk interpretation. Therefore, the mechanism underlying the link between analysts’ target prices and stock recommendations is not conclusive.