The Performance of Mechanical Earnings Forecasts

Abstract

We analyze three different mechanical models to forecast earnings and compare their forecasts with those of analysts. Moreover, we evaluate implied cost of capital (ICC) estimates that are based on these forecasts. With our analyses we answer three open questions in the literature. 1) Do model forecasts or analysts’ forecasts perform better? 2) Are ICCs derived from analysts’ forecasts more reliable than ICCs based on model forecasts? And 3) does higher forecast performance also translate into more reliable ICCs? First, we find that analysts’ forecasts are even more accurate than the most accurate model forecasts. However, second, we find that model-based ICCs are always more reliable than analyst-based ICCs. Moreover, model-based ICCs are particularly reliable for a sample of firms for which no analysts’ forecasts are available. While the lack of reliability of analyst-based ICCs seems to indicate a missing link between forecast performance and ICC reliability, in fact, third, we find that ceteris paribus higher forecast performance translates into more reliable ICCs, that is, within one earnings definition the most accurate forecasts also yield the most reliable ICCs.