Both bond rating agencies and equity analysts evaluate publicly traded companies releasing their opinions to investors. Yet, the quality of this information can be extremely volatile. A large number of studies have investigated the accuracy of debt and equity analysts’ research and the price effect of the release of new information to the market. Both rating actions and equity research revisions have proven to deliver consistent and statistically significant price effect on the underlying asset classes, thus allowing to conclude that investors consider this information valuable. Predicting rating actions would therefore be beneficial to both companies and investors. Surprisingly, though, only a few studies have addressed this issue. In this paper we develop a model to predict rating actions by looking at previously issued target prices. Since target prices provide a valuation of the equity value of a company which is by its very nature more volatile, a change in target prices could signal a change in the underlying robustness of a company’s operations which can eventually have an impact on debt rating. Collecting a unique dataset of 416 rating actions and 14.046 target prices issued by 75 different equity analysts and 3 different rating agencies on companies listed in the European market (UK, Germany, Euronext, France and Italy) between 1/1/2000 and 12/31/2005, we find that positive rating events are anticipated by consistent increases of the target prices released in the four months before the rating action. The evidence is slightly weaker for negative rating events, since significant reductions in target prices are observable only in a shorter window (three months). Our results are aligned with previous studies showing analysts’ overly optimistic behavior and analysts’ reluctance in reducing target prices over time. Controlling for the macro industry of each company, we find evidence that target prices are more likely to predict a rating action for financial rather than industrial companies which supports Gropp and Richards (2001) and Schweitzer et al. (1992) results who point out that differences in regulatory regimes, which imply different degrees of transparency, may affect the quality and accuracy of publicly available information.
Do target prices predict rating changes?
A. Salvi
2009-01-01
Abstract
Both bond rating agencies and equity analysts evaluate publicly traded companies releasing their opinions to investors. Yet, the quality of this information can be extremely volatile. A large number of studies have investigated the accuracy of debt and equity analysts’ research and the price effect of the release of new information to the market. Both rating actions and equity research revisions have proven to deliver consistent and statistically significant price effect on the underlying asset classes, thus allowing to conclude that investors consider this information valuable. Predicting rating actions would therefore be beneficial to both companies and investors. Surprisingly, though, only a few studies have addressed this issue. In this paper we develop a model to predict rating actions by looking at previously issued target prices. Since target prices provide a valuation of the equity value of a company which is by its very nature more volatile, a change in target prices could signal a change in the underlying robustness of a company’s operations which can eventually have an impact on debt rating. Collecting a unique dataset of 416 rating actions and 14.046 target prices issued by 75 different equity analysts and 3 different rating agencies on companies listed in the European market (UK, Germany, Euronext, France and Italy) between 1/1/2000 and 12/31/2005, we find that positive rating events are anticipated by consistent increases of the target prices released in the four months before the rating action. The evidence is slightly weaker for negative rating events, since significant reductions in target prices are observable only in a shorter window (three months). Our results are aligned with previous studies showing analysts’ overly optimistic behavior and analysts’ reluctance in reducing target prices over time. Controlling for the macro industry of each company, we find evidence that target prices are more likely to predict a rating action for financial rather than industrial companies which supports Gropp and Richards (2001) and Schweitzer et al. (1992) results who point out that differences in regulatory regimes, which imply different degrees of transparency, may affect the quality and accuracy of publicly available information.
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