Do analysts’ target prices stabilize the stock market?

Abstract

If target prices reflect the true values of stocks, they should direct prices towards intrinsic values. But analysts’ optimism and use of less sophisticated valuation methods have been found to impede target price informativeness. Contrary to conventional belief, we propose that, due to analysts’ optimism, target prices are closer to intrinsic values, and hence more informative, when investor sentiment is low. Accordingly, we find that the association of target prices with future returns is highest when investor sentiment is low and target prices are inferred to be based on sophisticated valuation methods. When investor sentiment is high, however, we find that the association of target prices with future returns approaches zero, suggesting that analyst optimism drives target prices away from intrinsic values, irrespective of the implied valuation method. Further, investors’ reactions to target price revisions are strongly positive and seemingly irrational with high investor sentiment—which potentially destabilizes markets.