A new perspective on post‐earnings‐announcement‐drift: Using a relative drift measure

Prior research finds that there is a delayed reaction to both analyst‐based earnings surprises and random‐walk‐based earnings surprises. Focusing on the market reaction from the post‐announcement window, prior studies show that analyst‐based drift is larger than random walk‐based drift. This finding is counter‐intuitive if we believe large, sophisticated investors tend to trade on analysts’ forecast earnings news and thus react faster and more completely than smaller and less sophisticated investors react to random walk earnings news. In this study, we construct a relative measure of post‐earnings‐announcement drift (PEAD) (i.e., drift as a proportion of total market reaction to earnings news) which we refer to as the ‘drift ratio’, and we provide evidence, consistent with our intuition, that analyst‐based drift ratio is smaller (not greater) than random‐walk‐based drift ratio. We find that this difference is more pronounced in more recent periods and for firms with more sophisticated investors. Our approach to measure the PEAD is more intuitive than that in traditional PEAD literature. Our results thus complement existing research findings by utilizing the drift ratio measure to generate new insights about the drift phenomenon.     

Analyst underreaction and the post-forecast revision drift

The post-forecast revision drift (PFRD), the phenomenon of delayed stock price reactions to analyst forecast revisions, is a well-documented market anomaly. Prior research attributes PFRD to underreaction by investors to analyst forecast revisions. This study investigates the role of the analyst forecast revision process itself in the PFRD anomaly. Using a large sample of US firms, we confirm prior findings of a positive serial correlation (momentum) in individual analysts’ revisions to their earnings forecasts and, based on both indirect and direct tests, document a positive association between this momentum and PFRD. Further analyses reveal that both the forecast revision momentum and PFRD vary in similar ways with respect to the nature of the news driving the revisions and the information environment. Collectively, our findings show that underreaction by individual analysts in the forecast revision process is an important contributor to the PFRD phenomenon.     

Analysts’ and Investors’ Reactions to Consistent Earnings Signals

We investigate (1) whether the trajectory of the current‐quarter earnings expectation path (defined by the signs of the forecast revision and the earnings surprise) provides information about future firm performance, and (2) the extent to which analysts and investors react to that information. Our results indicate that analysts underreact more to earnings information revealed by consistent‐signal earnings expectation paths than to earnings information communicated by inconsistent‐signal expectation paths. We also find that the current earnings expectation path provides incremental explanatory power for future abnormal returns, even after controlling for the sign and magnitude of the earnings surprise. Overall, our evidence is consistent with underreaction stemming from analysts’ and investors’ bias in processing the information in consistent‐signal earnings expectation paths.     

Conditional Persistence of Earnings Components and Accounting Anomalies

We suggest that the failure of investors to distinguish between an earnings component's autocorrelation coefficient (unconditional persistence) and the marginal contribution of that component's persistence to the persistence of earnings (conditional persistence) provides a partial explanation of post‐earnings‐announcement drift, post‐revenue‐announcement drift, and the accrual anomaly. When the conditional persistence of revenue surprises is high (low) relative to its unconditional persistence, both the post‐earnings‐announcement drift and the post‐revenue‐announcement drift are high (low), because investors’ under‐reaction to revenues and earnings is stronger when the persistence of revenue surprises is more strongly associated with the persistence of earnings surprises. Also, the mispricing of accruals decreases substantially when the conditional persistence of accruals is high relative to its unconditional persistence, because investors’ over‐reaction to accruals is mitigated when the persistence of accruals is indeed more strongly associated with the persistence of earnings. Our findings also suggest that financial analysts’ failure to distinguish between unconditional and conditional persistence of revenues and accruals results in more biased revenue and earnings predictions.     

Management forecast credibility and underreaction to news

In this paper, we first document evidence of underreaction to management forecast news. We then hypothesize that the credibility of the forecast influences the magnitude of this underreaction. Relying on evidence that more credible forecasts are associated with a larger reaction in the short window around the management forecasts and a smaller post-management forecast drift in returns, we show that the magnitude of the underreaction is smaller for firms that provide more credible forecasts. Our paper contributes to the literature by providing out-of-sample evidence of the drift in returns documented in the post-earnings-announcement drift literature, with the credibility of the news being one explanation for the phenomenon.     

Investor and Analyst Reactions to Earnings Announcements of Related Firms: An Empirical Analysis

In this article I examine the response of investors and analysts of nonannouncing firms to the earnings report of the first announcers in the industry. The error in the earnings forecast of the first announcer is found to be informative about the errors in the contemporaneous earnings forecasts of subsequent announcers in the industry. However, investors and analysts do not appear to fully incorporate the information from the first announcers' news in their revised earnings expectations for subsequent announcers. This apparent underreaction to the first announcers' news leads to predictable stock returns for subsequent announcers in the days following the first announcement. Results of this study can be seen as further evidence of investor and analyst underreaction to publicly available information.     

Investor and (Value Line) Analyst Underreaction to Information about Future Earnings: The Corrective Role of Non-Earnings-Surprise Information

Prior research suggests that financial analysts' earnings forecasts and stock prices underreact to earnings news. This paper provides evidence that analysts and investors correct this underreaction in response to the next earnings announcement and to other (non-earnings-surprise) information available between earnings announcements. Our evidence also suggests that analysts and investors underreact to information reflected in analysts' earnings forecast revisions and that non-earnings-surprise information helps correct this underreaction as well. Controlling for corrective non-earnings-surprise information significantly increases estimates of the degree to which analysts' forecasting behavior can explain drifts in returns following both earnings announcements and analysts' earnings forecast revisions.     

Investor Inattention and Friday Earnings Announcements

Does limited attention among investors affect stock returns? We compare the response to earnings announcements on Friday, when investor inattention is more likely, to the response on other weekdays. If inattention influences stock prices, we should observe less immediate response and more drift for Friday announcements. Indeed, Friday announcements have a 15% lower immediate response and a 70% higher delayed response. A portfolio investing in differential Friday drift earns substantial abnormal returns. In addition, trading volume is 8% lower around Friday announcements. These findings support explanations of post‐earnings announcement drift based on underreaction to information caused by limited attention.     

Insider trading,future earnings,and post-earnings announcement drift

This paper examines the association between insider trading prior to quarterly earnings announcements and the magnitude of the post-earnings announcement drift (PEAD). We conjecture and find that insider trades reflect insiders’ private information about the persistence of earnings news. Thus, insider trades can help investors better understand and incorporate the time-series properties of quarterly earnings into stock prices in a timely and unbiased manner, thereby mitigating PEAD. As predicted, PEAD is significantly lower when earnings announcements are preceded by insider trading. The reduction in PEAD is driven by contradictory insider trades (i.e., net buys before large negative earnings news or net sells before large positive earnings news) and is more pronounced in the presence of more sophisticated market participants. Consistent with investors extracting and trading on insiders’ private information, pre-announcement insider trading is associated with smaller market reactions to future earnings news in each of the four subsequent quarters. Overall, our findings indicate insider trading contributes to stock price efficiency by conveying insiders’ private information about future earnings and especially the persistence of earnings news.     

Post‐Earnings Announcement Drift: Bounds on Profitability for the Marginal Investor

The persistence of the post‐earnings announcement drift (PEAD) leads many to believe that trading barriers prevent investors from eliminating it. We examine two factors that have not been adequately addressed by the literature: the exact timing of earnings announcements and liquidity costs. Under a wide range of timing and cost assumptions, our results leave little doubt that over our sample period the PEAD was highly profitable after trading costs. An additional incremental investor could have earned hedged‐portfolio returns of at least 14% per year after trading costs. Over our sample period, investors did indeed leave money on the table.     

How do the content,format, and tone of Twitter-based corporate disclosure vary depending on earnings performance?

Using 86,891 tweets, from the official corporate Twitter accounts of 715 unique firms, this study examines whether and how managers strategically attract and distract investors’ attention from corporate news through Twitter. We find that firms with good earnings news use Twitter to post more earnings-related information directly, whereas firms with bad earnings news post more non-earnings-related information on Twitter. We further find that depending on earnings performance firms strategically choose the format of tweets (qualitative or quantitative) and the tone of earnings tweets (positive or negative) to attract investors’ attention to good news or distract investors’ attention from bad news. Our results are robust to difference-in-differences (DID), alternative sample periods, and different variable specifications. Our findings provide empirical evidence for investors and regulators regarding current practices in corporate information on Twitter.     

Media heterogeneity and post‐earnings announcement drift: evidence from China

This paper examines how the Chinese stock market acts differently towards state‐controlled and market‐oriented media coverage. Using a setting of post‐earnings announcement drift, we find that information from state‐controlled media enters the stock price in a timelier manner, while the message from market‐oriented media needs more time to get a response from investors. The effect is also influenced by whether the type of news coverage is good or bad. Our findings suggest that the capital market underreacts when good news is reported by the market‐oriented media.     

Unsophisticated Arbitrageurs and Market Efficiency: Overreacting to a History of Underreaction?

Prior research has documented that arbitrage activity significantly reduces or eliminates stock market anomalies. However, if anomalies arise due to unsophisticated investors’ behavioral biases, then these same biases can also apply to unsophisticated arbitrageurs and thereby disrupt the arbitrage process. Consistent with a disruption in the arbitrage process for the post‐earnings announcement drift anomaly, I document that the historically positive autocorrelation in firms’ earnings announcement news has become significantly negative for firms with active exchange‐traded options. For these easy‐to‐arbitrage firms, the firms in the highest decile of prior earnings announcement abnormal return (prior earnings surprise), on average, underperform the firms in the lowest decile by 1.59% (1.43%) at their next earnings announcement. Additional analyses are consistent with investors learning about the post‐earnings announcement drift anomaly and overcompensating. This study suggests that unsophisticated attempts to profit from a well‐known anomaly can significantly reverse a previously documented stock return pattern.     

When Good News Is Not So Good: Economy‐wide Uncertainty and Stock Returns

This paper shows that variation in economy‐wide uncertainty causes asymmetric stock price responses to firm earnings surprises. The uncertainty that attends bad earnings news that arrives during expansions with greater economy‐wide uncertainty occasions larger price declines. This is because news inconsistent with investors’ prior beliefs about the state of the economy increases uncertainty, which amplifies the negative cash flow effects contained in bad earnings news. Asymmetrically, the positive cash flow effect of good earnings news that arrives during recessions is offset by increased investor uncertainty, which results in relatively smaller price reactions to the good news. This is consistent with Veronesi's rational expectations equilibrium model, which shows that investors demand higher expected returns in the face of greater uncertainty.     

Contemporaneous verification of language: evidence from management earnings forecasts

Research documents that linguistic tone is incrementally informative about stock returns. What remains a puzzle is the mechanism by which investors can assess its credibility. We examine whether contemporaneous information in management earnings forecasts serves as a timely alternative to ex post verification. We document that ex post verifiable quantitative news in unbundled forecasts, and characteristics of the linguistic tone itself, affect investors’ pricing of tone. Consistent with higher quality signals enhancing the credibility of contemporaneous lower quality signals, we find that quantitative news verifies the associated linguistic tone; when the two signals have the same sign, the price effect of tone is stronger. Furthermore, the pricing attenuation of tone is increasing in the imprecision of the quantitative forecast, suggesting that lower forecast quality compromises the quantitative signal’s credibility enhancement. Managerial incentives to inflate tone lead to the verification effect being greater for optimistic language, while management’s use of hyperbole results in attenuation of the tone’s pricing.     

Earnings expectations,investor trade size,and anomalous returns around earnings announcements

We provide evidence that identifiable subsets of investors use significantly different information sets. Investors initiating large trades respond to analysts’ earnings forecast errors, while investors initiating small trades respond to a less-sophisticated signal that underestimates the implications of current earnings innovations for future earnings levels. This suggests small investors exhibit the behavior that Bernard and Thomas [Journal of Accounting and Economics 13, 305–340] theorize causes post-earnings announcement drift. We also use analysts’ forecasts to significantly improve the predictability of returns around earnings announcements previously documented by Bernard and Thomas. Finally, results attempting to link return predictability to the prevalence of small-investor trading are mixed.     

Measuring investors’ assessment of earnings persistence: do investors see through smoothed earnings?

Prior studies document that investors value persistent earnings more than transitory earnings. This argument offers incentives to managers to smooth their reported earnings and make them look more persistent. This study examines whether investors are misled by management’s income-smoothing behavior and whether they can correctly assess the persistence of smoothed earnings. Using a simple theoretical model, this paper shows that investors’ assessment of earnings persistence can be derived from their reactions to reported earnings, which is the ratio of the coefficient on earnings change relative to the coefficient on earnings level in the return–earnings relation. Empirical results show that investors’ assessment of earnings persistence is negatively associated with the level of income smoothing after controlling for time-series persistence of earnings and hence suggest that investors understand that the high persistence of smoothed earnings is not real and they discount the persistence of smoothed earnings when they react to such earnings news.     

Non‐GAAP Earnings Disclosure in Loss Firms

This study examines the incremental information in loss firms’ non‐GAAP earnings disclosures relative to GAAP earnings. Using a large sample obtained through textual analysis and hand‐collection, we posit and find that loss firms’ non‐GAAP earnings exclusions offset the low informativeness of GAAP losses for forecasting and valuation. Loss firms’ non‐GAAP earnings are highly predictive of future performance and are valued by investors, while the expenses excluded from GAAP earnings are not. Additional tests suggest that loss firms disclosing non‐GAAP profits have significantly better future performance than GAAP‐only loss firms and are not overvalued by investors. Comparing non‐GAAP earnings of profitable firms to those of loss firms, we find that loss firms’ non‐GAAP metrics are significantly more predictive and less strategic. We conclude that non‐GAAP earnings disclosures are particularly informative about loss firms and help investors disaggregate losses into components that have differential implications for forecasting and valuation.     

Why Do Managers Explain Their Earnings Forecasts?

Managers often explain their earnings forecasts by linking forecasted performance to their internal actions and the actions of parties external to the firm. These attributions potentially aid investors in the interpretation of management forecasts by confirming known relationships between attributions and profitability or by identifying additional causes that investors should consider when forecasting earnings. We investigate why managers choose to provide attributions with their forecasts and whether the attributions are related to security price reactions to management earnings forecasts. Using a sample of 951 management earnings forecasts issued from 1993 to 1996, we find that attributions are more likely for larger firms, less likely for firms in regulated industries, less likely for forecasts issued over longer horizons, more likely for bad news forecasts, and more likely for forecasts that are maximum type. Furthermore, attributions are associated with greater absolute price reactions to management forecasts, more negative price reactions to management forecasts (forecast news held constant), and a greater price reaction per dollar of unexpected earnings. Our findings hold after control for the aforementioned determinants of attributions and after control for other firm‐ and forecast‐specific variables that are often associated with security prices.     

Are corporate managers savvy about their stock price? Evidence from insider trading after earnings announcements

We find that insiders trade as if they exploit market underreaction to earnings news, buying (selling) after good (bad) earnings announcements when the price reaction to the announcement is low (high). We also find that insider trades attributable to public information about earnings and the price reaction generate abnormal returns. By demonstrating that managers spot market underreaction to earnings news, our results imply that managers are savvy about their company’s stock price.