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Is the focus that investors and managers have on analysts’ consensus estimates warranted? To answer this question, I computed for every year, 1995 through 2006, the percentage of analysts’ forecast error—the difference between reported annual EPS and the consensus EPS, relative to reported EPS—for four thousand to five thousand companies a year. I examined two forecast horizons: a twelve-month horizon using the first consensus estimate after the previous year’s earnings release, and a three-month (fourth quarter) horizon, using the first consensus estimate after the third-quarter earnings release. To provide a benchmark, I repeated the forecast error computation with an “extrapolation (naive) forecast,” where the prior year’s reported EPS (or the mean of the prior four quarters’ EPS, for the three-month prediction) competed with the analysts’ consensus. I thus compared analysts to a “dummy,” predicting that history repeats itself perfectly (someone quipped that history doesn’t repeat itself, only historians do).

My results showed that analysts’ (the consensus) median forecast error was 14.5 percent of reported earnings for the twelve-month horizon and 3.9 percent for the three-month horizon. The corresponding median forecast errors for the extrapolation forecast—which is free of charge, of course—are 23.7 percent for the yearly horizon and 13.8 percent for the three-month horizon. Analysts’ forecasts are obviously better than a simple extrapolation, and they show an improvement from 2002 to 2006. Also, in every year the mean errors are negative, indicating that analysts’ forecasts are optimistic, on average. Other research indicates that analysts’ forecasts improve with experience, breadth of industry coverage, and size of employer; and that following analysts’ stock recommendations (buy, hold, sell) will get you about 4 percent abnormal (above-market) gain annually, although much of it will be eaten up by transaction costs.⁷ (Findings for European analysts are quite similar.⁸) The lesson is, don’t rush to dismiss analysts as quacks.