ACCOUNTING EARNINGS AND STOCK PRICES

Information Content of Earnings

• Distinguish between:– Earnings reflecting factors that affect stock

prices– Earnings announcements conveying

information to the stock market• To test this hypothesis: observe the stock price

change at the time the earnings are announced.

Information Content of Earnings (Cont’d)

• There are many alternative sources of information on a firm’s cash flows that can reduce the information content of earnings announcement

Sign of Unexpected Earnings and Mean Abnormal Returns

• Ball and Brown (1968):– Investigates the relation between the sign

of unexpected earnings and mean abnormal rates of return

• Other studies of annual earnings– BB study has been replicated for annual

earnings announcements by firms traded in U.S. markets other than the NYSE and for firms traded in other countries results are not unique to the NYSE.

Sign of Unexpected Earnings and Mean Abnormal Returns

• Other studies of annual earnings– Braun (1970):

• Australian companies. • Differences: price adjustment during the year is

less rapid on Australian Exchanges than on NYSE and there is more price adjustment in the announcement month on the Australian Exchanges.

– Australian companies issue semiannual instead of quarterly reports

– Australian firms are, on average, much smaller than NYSE firms

• Interim earnings– Creates some problems in interpreting Ball

& Brown’s results:• Interim reports could be responsible for some

of the stock price adjustment to annual earnings that occur in the year before the annual earnings announcements.

• Information content of the earnings announcements could be understated/overstated.

Sign of Unexpected Earnings and Mean Abnormal Returns (Cont’d)

• Interim earnings– Foster (1977):

• The evidence is consistent with the hypothesis that quarterly earnings reflect factors impounded in stock prices and quarterly earnings convey information to the capital market.

Sign of Unexpected Earnings and Mean Abnormal Returns (Cont’d)

Magnitude of Unexpected Earnings and Mean Abnormal Returns

• Beaver, Clarke, and Wright (1979)– Investigate the magnitude– There is a relation between the magnitude

of the unexpected earnings change and the abnormal rate of return.

• Beaver, Lambert, and Morse (1980)– Consistent result

Earnings Announcements and Variance of Abnormal Returns

• Beaver (1968a)– To avoid specifying a model for expected earnings– Average abnormal return variance is larger in the

week of announcement of annual earnings.

• Other Variance Studies– May (1971): American Stock Exchange (ASE)– Hagerman (1971): OTC market

Both results are similar to Beaver’s

Earnings Announcements and Implicit Return Variances

• Patell & Wolfson (1979, 1981): use call option prices to test whether the market anticipates the variance increase at the time of earnings announcements.– The evidence is consistent with the market

anticipating the release of the information in earnings announcements.

Earnings Announcements and Trading Volume

• Beaver (1968a): also investigates changes in the volume of trading associated with earnings announcements.– Results: large increase in volume in the

earnings announcement week

Earnings announcements convey information to the stock market

Earnings and Cash Flows

• Several studies (Ball & Brown (1968), Beaver & Dukes (1972)) find that current cash flows are less highly associated with abnormal returns.

• Patell & Kaplan (1977): cash flows do not have marginal information content.

• It should be noted: none of those studies actually uses operating cash flows.

• It would be interesting to use total net cash flows instead of operating cash flows

Variation in Information Content

• Grant (1980)– The information content of earnings

announcements varies with the number of alternative source of information.

• McNichols & Manegold (1983)– Reduction in the relative information

content of annual earnings announcements following the introduction of quarterly reporting.