Contemporary Accounting Research Vol. 26 No. 2 (Summer 2009) pp. 329–57 © CAAA doi:10.1506/car.26.2.1 Further Evidence on the Relation between Analysts’ Forecast Dispersion and Stock Returns* ORIE E. BARRON, Pennsylvania State University MARY HARRIS STANFORD, Texas Christian University YONG YU, University of Texas at Austin 1. Introduction Prior research reports seemingly conflicting evidence and interpretations concern- ing the relation between dispersion in analysts’ earnings forecasts and stock returns. Both Diether, Malloy, and Scherbina (2002) and Johnson (2004) provide evidence that investors pay a premium for stocks with high dispersion in analysts’ forecasts, which leads to lower future stock returns; that is, levels of dispersion are negatively associated with future stock returns. However, these two studies argue that this relation exists for different reasons: Diether et al. claim that it results from over- pricing due to information asymmetry, while Johnson argues that it results from uncertainty that increases the option value of the firm. Additionally, both studies suggest a positive relation between changes in dispersion and contemporaneous stock returns that is contrary to the negative relation reported by L’Her and Suret 1996. This study reconciles and extends the findings in these studies. Diether et al. (2002) demonstrate that firms with high levels of forecast disper- sion earn lower future monthly returns. They argue that the lower returns are caused by market frictions that result in overpricing. When investors have asym- metric information sets, and short sale limitations (or any market friction) prevent pessimists from trading, prices reflect the views of optimists and stocks are over- priced. This suggests (a) a negative relation between dispersion levels and future stock returns when the overpricing is corrected and (b) a positive relation between changes in dispersion and contemporaneous stock returns when the overpricing occurs. Diether et al. provide evidence supporting the first point, that dispersion levels are negatively related to future stock returns. They conclude that disper- sion levels proxy for differences of opinion due to asymmetric information and that “our results strongly reject the interpretation of dispersion in analysts’ fore- casts as a measure of risk” (Diether et al. 2002, 2115). * Accepted by Patricia O’Brien. We gratefully acknowledge the contribution of I/B/E/S Interna- tional Inc. for providing earnings per share forecast data, available through I/B/E/S. I/B/E/S provides these data as part of a broad academic program to encourage earnings expectation research. For their helpful comments we thank Linda Bamber, Sandy Callaghan, Richard Schneible, and workshop participants at Wharton, CUNY Baruch, the University of Georgia, Uni- versity of Minnesota, and Pennsylvania State University.