The influence of market competition on the ability to forecast future profits

3 October 2018

Competitive pressure influences many business choices, including accounting and financial ones, as companies adapt their strategies to changing environmental conditions. For example, empirical studies show that companies operating in more competitive markets distribute less dividends and try to hold more cash to respond promptly to the aggressive strategies of competitors. The level of competition is therefore a variable that negatively affects investment in capital and in research and development, especially when barriers to entry into a market are low, with effects on future growth prospects.

Financial analysts are professionals who study listed companies, largely through the use of published financial statements, to suggest to their clients the possible purchase of shares or bonds. In this regard, analysts can be seen as intermediaries that process complex information (primarily data and information in financial statements) to help investors make decisions about allocating their savings (that is, buying a certain stock or not ). This activity typically consists of the forecast of future profits (or Earnings Per Share) to which a certain expected price is associated.

In a recent article, published in the quarterly journal Review of Accounting Studies, Marco Maria Mattei, Director of the Master in Finance, Control and Auditing of Bologna Business School, and Petya Platikanova, Associate Professor at the ESADE Business & Law School, investigated if and how the competitive pressure on the product modifies the accuracy of the analysts’ forecasts on profits and what are the causes of this eventual minor or greater precision.

The existence and the sign of a relationship between competition and predictive ability of analysts are not to be taken for granted. On the one hand, in fact, the greater market competition can be expected to increase the volatility of future cash flows and, consequently, make it more difficult to forecast future corporate performance. On the other, it is possible that greater competition will induce companies to change the quantity and quality of information provided to the market through financial statements, in two opposite directions: to communicate more to the markets, to reassure them and keep the cost of the loans low (thus facilitating analysts’ forecasting work); or communicate less to the markets, for fear that competitors reading the financial statements will acquire too much information on current decisions and future prospects (thus making analysts’ forecasting work more difficult).

The study shows that effectively increasing competition reduces the accuracy of analysts’ forecasts, but that this reduction is only partially explained by the increase in performance volatility. As the competitive threat increases, in fact, companies on average reduce the quality of information in the financial statements and limit the disclosure to the minimum required by law. The combined effect of the increase in volatility of performance and a decline in the qualitative and quantitative level of information provided by companies, therefore, makes the forecast of future profits much more difficult for financial analysts.

This result highlights the need for analysts to develop and use predictive models with increasing intensity based on a plurality of information sources, able to neutralize any budgetary policies implemented by companies.

 

 

by Marco Maria Mattei, Director of the Master in Finance, Control and Auditing