What are the roles of changes in earnings forecasts and the discount rate on stock valuation during the COVID-19 stock market crash? In the May 2020 update of their paper entitled “Earnings Expectations in the COVID Crisis”, Augustin Landier and David Thesmar investigate firm-level analyst earnings forecast revisions and discount rate changes as jointly reflected in stock market behavior during COVID-19 discovery and spread. They further decompose the effect of discount rate changes into impacts of: (1) change in interest rates, (2) change in equity risk premium and (3) the leverage effect (declining stock prices driving an increase in expected equity return). Using analyst earnings forecasts and prices for the top 1000 U.S. stocks by market capitalization as of year-end 2019, and contemporaneous interest rates, during January 2020 through mid-May 2020, they find that:
- Downward earnings forecast revisions focus on 2020, 2021 and 2022, with forecasts for 2020 progressively reduced by 16%. Longer-term revisions are less negative and exhibit less disagreement. Overall, assuming a constant discount rate, the stream of revisions translates to a simple average return of -12% across stocks.
- Based on known forecast revisions and actual stock price movements, the implied valuation discount rate rises from 10% in mid-February to 13% at the end of March, and reverts to 10% in mid-May. Discount rate behavior is the main driver of the V-shaped evolution of stock prices during this period.
- The leverage effect produces a 2% increase in discount rate at the end of March, reverting to a 1% decrease in mid-May after the market rebound. The equity risk premium returns to its mid-February level by mid-May, with the leverage effect and interest rate decline offsetting.
In summary, analyst forecast revisions explain most of the decrease in equity values between January 2020 and mid May 2020, but they do not explain the sharp V-shaped stock market evolution in between.
In other words, some decline in the stock market derives from lowered expectations for firm earnings, and some derives from temporarily elevated risk aversion.
Cautions regarding findings include:
- While perhaps applicable to future events, findings are retrospective rather than predictive.
- Other disruptive events may have materially different effects on earnings forecasts and valuation discount rates.
For a different approach, see “Impact of COVID-19 on Markets and Economies”.
