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This paper provides empirical evidence that underreaction in financial analysts' earnings forecasts increases with the forecast horizon, and offers a rational economic explanation for this result. The empirical portion of the paper evaluates analysts' responses to earnings‐surprise and other earnings‐related information. Our empirical evidence suggests that analysts' earnings forecasts underreact to both types of information, and the underreaction increases with the forecast horizon. The paper also develops a theoretical model that explains this horizon‐dependent analyst underreaction as a rational response to an asymmetric loss function. The model assumes that, for a given level of inaccuracy, analysts' reputations suffer more (less) when subsequent information causes a revision in investor expectations in the opposite (same) direction as the analyst's prior earnings‐forecast revision. Given this asymmetric loss function, underreaction increases with the risk of subsequent disconfirming information and with the disproportionate cost associated with revision reversal. Assuming that market frictions prevent prices from immediately unraveling these analyst underreac‐tion tactics, investors buying (selling) stock on the basis of analysts' positive (negative) earnings‐forecast revisions also benefit from analyst underreaction. Therefore, the asymmetric cost of forecast inaccuracy could arise from rational investor incentives consistent with a preference for analyst underreaction. Our incentives‐based explanation for underreaction provides an alternative to psychology‐based explanations and suggests avenues for further research.

Researchers argue that analysts’ information acquisition efforts increase firm value by facilitating monitoring of firms’ activities and, thereby, reducing agency costs. However, prior research provides limited and inconclusive empirical evidence to support this argument. This article extends the literature by examining (a) the relationship between analyst following and the value of firms’ equity securities and (b) given a positive relationship, whether that relationship reflects effectively enhanced monitoring of firms’ activities as a result of analysts’ information acquisition efforts. The authors document a positive relationship between analyst following and firms’ asset values, and they find support for two hypotheses regarding the source of the increased asset values. First, the cash component drives the positive relationship between analyst following and asset values. The authors interpret this evidence to imply a stronger monitoring effect for assets that are subject to higher agency costs or information asymmetry. Second, consistent with analyst following constraining asset mismanagement or motivating more efficient asset use, operating performance and total cash payout increase with analyst following. Overall, the results suggest that financial analysts facilitate more effective monitoring of firms’ activities and, thereby, reduce agency costs and increase shareholder value.

We study the relation between issuer operating performance and initial public offering (IPO) price formation from the initial price range to the offer price to the closing price on the first trading day. For a post‐bubble sample of 2001–2013 IPOs, we find that pre‐IPO net income and, in particular, operating cash flow are strongly, positively associated with the revision from the mid‐point of the initial price range to the offer price and that the “partial adjustment phenomenon” concentrates among issuers with the strongest operating performance. As for why publicly observable information helps predict changes in valuation from when the initial price range is set to when the offer price is set, our findings suggest that strong‐performing issuers, especially those offering small slices of ownership, have lower bargaining incentives and are susceptible to the underwriter(s) low‐balling the price range. Overall, our results suggest an important role for accounting information in understanding the pricing of book‐built IPOs and are consistent with the presence of agency problems between issuers and underwriters.