Further evidence on the relation between analysts' forecast dispersion and stock returns

Prior research reports seemingly conflicting evidence and interpretations concerning the relation between dispersion in analysts' earnings forecasts and stock returns. Previous studies have shown a negative relation between levels of dispersion in analysts' forecasts and future stock returns. Yet, changes in forecast dispersion are negatively associated with contemporaneous stock returns. We demonstrate that levels and changes in dispersion reflect different theoretical constructs. Changes in dispersion primarily reflect changes in information asymmetry, whereas levels of dispersion primarily reflect levels of uncertainty. Further, the uncertainty component of dispersion levels reflects idiosyncratic risk that is negatively associated with future stock returns. These findings provide support for the theory that dispersion levels reflect idiosyncratic uncertainty that increases the option value of the firm and generally refute the explanation that dispersion levels reflect information asymmetry. In addition, we reconcile the conflicting findings outlined above. We find that the negative association between changes in dispersion and contemporaneous stock returns is not due to increased uncertainty but rather to increased information asymmetry.