Professional Documents
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Journal
016Y-207O/Y3/$06.00
9 ( 1993) 295-320
of Forecasting
@ 1093 Elsevicr Science Publishers
20s
B.V. All rights
reserved
its implications
D. Brown
State University
of New
York
at Buffalo,
Buffalo,
NY
14260-4000,
USA
Abstract
Since the early 198Os, earnings forecasting
research has become much more closely aligned with
capital markets research.
Capital markets research requires a proxy for the (unobservable)
market
earnings
expectation
and earnings forecasting
research has provided such proxy measures.
Questions
considered
in this paper include: (1) if annual earnings follow a random walk or an IMA (1 ,I) model,
does this mean that earnings
changes cannot be predicted?
(2) Do stock prices act as if quarterly
earnings follow a seasonal random walk with drift process? (3) Is the predictive mode1 which is best on
the forecast accuracy dimension
also best on the market association
dimension?
(4) How do analysts
formulate
their earnings expectations?
(5) What is the role of earnings forecasting in earnings response
coefficient
and post-earnings
announcement
drift studies? (6) What is the likely role of earnings
forecasting
research in future capital market studies?
Keywords: Earnings
forecasting;
drift; Future research
Forecast
accuracy;
1. Introduction
When Paul Griffin and I issued a call for
papers for the Special Issue on Accounting
and
Finance
of the Journal of Forecasting
[Brown
and Griffin (1983)], most of the papers we received were concerned
about whether
annual
earnings follow a random walk (or random walk
with drift) process. Nevertheless,
this issue was
pretty much resolved
by the late 1970s. Little
(1962) provided evidence that British firms annual earnings follow a random walk process and
several
studies
of US firms [Ball and Watts
*Earlier versions of this paper were presented
at Columbia
University.
SUNY at Buffalo and the University of Waterloo.
I am grateful for the valuable comments
of Paul AndrC. Eli
Bartov, Sasson Bar-Yosef,
M. Daniel Ben&h,
Dan Coggin,
Robert Fildes, Bob Hagerman.
Jerry C. Y. Han, Tom Lechncr, John OHanlon,
Wonsun
Paek, Gordon
Richardson,
Kevin Sachs, Jake Thomas and Mark Zmijewski.
Market
association;
Post-earnings
announcement
(1972), Albrecht
et al. (1977), Watts and Leftwith (1977)] showed that Box-Jenkins
(1976)
autoregressive
integrated
moving
average
(ARIMA)
models confined
to annual
earnings
data did not generate more accurate forecasts. in
a holdout period, than those based on a random
walk model. While the papers published
in the
special issue did not focus on whether
annual
earnings follow a random walk (or random walk
with drift) process, most did focus on earnings
forecasting
and lacked implications
for capital
markets research.
A major change in the earnings forecasting
literature
took place in the
1980s; it became much more closely linked with
capital markets research.
Prior to Foster (1977), the earnings forecasting
literature
focused
on predictive
ability
and
evaluated
earnings expectation
models solely on
their ability to forecast future earnings
(hereafter, accuracy). Foster introduced
an alternative
way to evaluate
earnings
expectation
models,
namely contemporaneous
market association
of
abnormal
returns with earnings
surprise,
conditional upon the expectation
model. (Hereafter,
we shall refer to Fosters method as the association approach.)
He argued that. given the maintained
hypothesis
of an efficient
market,
the
strength of association
between abnormal returns
and earnings
surprise
indicates
how accurately
the model captures
the markets
expectation.
Since the capital markets
literature
requires
a
proxy for the markets earnings expectation.
the
association
approach made the earnings forecasting literature
important
for capital markets research. especially
when abnormal
returns were
measured
over a narrow window,
such as the
-day
period,
(-I .O), where
Day 0 is the
announcement
day [Foster ( I977)].
In an informationally
efficient market. ignoring transactions
costs and costs of generating
and
processing
information,
the association
and predictive ability approaches
should provide similar
results. The argument
that predictive ability and
association
arc two sides of the same coin is
based on the assumption
that the capital market
uses the best data available.
where best is defined as most accurate. This notion is similar to
the rational
expectations
principle
which maintains that the subjective
probability
distribution
of outcomes
is distributed
as the objective probability distribution
of outcomes
[Muth (1961 )].
In the early l%Os, researchers
began to use
the dual criteria of accuracy and association
to
evaluate
earnings forecasting
models. Fried and
Givoly (19X2) and Brown et al. (1%7a,b),
respectively.
used these same dual criteria to compare analysts
annual
and quarterly
earnings
forecasts
with those of univariate
time-series
models.
These
studies
showed
that analysts
earnings forecasts are better than those of timcseries models when both criteria are used and
suggested that analysts earnings forecasts should
be used in lieu of time-series
model forecasts,
when a proxy for the markets earnings cxpectations is required.
When analyst
data became
widely available
in machine-readable
form. academics began to use analysts earnings forecasts
in lieu of time-series
model forecasts to proxy for
the markets unobservable
earnings expectation.
The remainder
of this article proceeds as follows. Section 2 discusses a branch of the earnings
forecasting
literature
which continued
to evolve
without direct links to capital markets research.
It examines
the time-series
properties
of annual
and quarterly
earnings;
what happens to predictive
accuracy
when
additional
information,
beyond
earnings.
is allowed for in the information
set; the analysts
earnings
expectation
process; how analysts earnings forecasts can be
improved;
biases in analysts earnings forecasts;
determinants
of analyst following.
Section 3 examines
the relation
between
accuracy and association;
past quarterly
earnings
numbers
and
post-earnings
announcement
drift: analyst
bchavior
and post-earnings
announcement
drift;
forecast
convergence
an d
post-earnings
announcement
drift; the relation
of analysts
forecasts to abnormal
returns.
The earnings response coefficient literature,
discussed in Section
4, examines
proxies for earnings surprise; determinants
coefficients
of
earnings
response
(ERCs); the functional
form of the ERC cstimation equation;
stock-price
and earnings cxpectations.
Sections 2. 3 and 4 summarize
and critique the
and offer some guidance
for future
literature,
research.
Section 5 focuses on some directions
for future research.
Included therein is the role
of analysts earnings forecasts as inputs for stockprice recommendations:
the role of analyst expcctational
data in post-earnings
announcement
drift studies;
the role of cxpectational
data if
forecast accuracy and association
are (or are not)
two sides of the same coin.
Section 6 provides implications
for other branches of forecasting
research. Special attention
is
paid to two notions: ( 1) the forecasting
literature
has recently
developed
a number
of themes
which have been addressed
by the literature
surveyed
in this paper; (2) the intellectual
focus
of forecasting
research can be sharpened,
and its
impact enhanced.
if it broadens
its perspective
beyond
examining
forecasts
as ends in themselves.
2. A continuation
of the earnings
forecasting
literature
-7. 1. Tirnr-series
One
branch
properties
oJ earnings
of earnings
forecasting
research
L. D. Brown
I Earnings
= B(B)O(B)cr,
+ e,,
where w, is a stationary
time-series;
B is the
backshift operator
such that Bh~lI = w,_~, 4(B)
and B(B) are polynomials
in B, namely 4(B) =
1 - &B- . . . -&B
and
0(B) = 1 - 0,B. -oqyBq, @(B)
and O(B),
the seasonal
parts of the model, have the form @(B) = 1 @,5Bs- . . -@,,,sBP
and
O(B) = 1 - O,sBs. . . - 0 ys .B, a, is an independent
and identitally distributed
white noise residual term with
mean zero and variance a,, l, and 0,, is a constant.
The model is of order (p,d,q)
x (P,D,Q).
Autoregressive
parameters
are denoted by p and P;
moving average parameters
by q and Q; d and D
are the degrees of ordinary
and seasonal
differencing
required to achieve stationarity.
Griffin (1977) and Watts (1975) proposed the
model:
(l-B)(l-B)X,=(l-O,B)(l-O,B)a,
per share.
the model:
207
research
(1 - $,B)(l
- B)X,
= (1 - &B4)q
(2)
(1)
where X, denotes quarterly
earnings
Brown and Rozeff (1979a) suggested
forrmsiing
(or random
walk with drift) model, some researchers
argued that annual earnings
with extreme year to year changes were better described
by a mean-reverting
model [Brooks and Buckmaster
(1976).
Salamon
and Smith (1977).
Beaver and Morse (1978)]. The mean-reverting
model, known as the ARIMA
(0.1 ,l) or integrated moving average (IMA) (1,l) model, has
been used in numerous
subsequent
studies by
accounting
researchers
[Beaver
et al. (lY80.
1987), Collins and Kothari (1989)].
Kendall and Zarowin
(1990), and Ramakrishnan and Thomas (1992) have shown that annual
earnings
are well-described
by a first-order
autoregressive
process in earnings
levels. In contrast with Brooks and Buckmaster
(1976). who
reject the random walk hypothesis
only for extreme earnings
changes,
these studies suggest
that the rejection
of the random walk model is
not confined
to cases of extreme
earnings
changes.
Ramakrishnan
and Thomas
(1992)
show that this behavior
has become more pronounced over time; the mean autocorrelations
at
the first lag in the excess earnings
time-series
(i.e. X, - X,_, - (R - 1)(X,_, - d,_ ,). where X
and d are net income and dividends,
respectively, and R. the required
return on equity, = 1.1)
are - 0.03
and - 0.16
for
the
two
20-year
periods,
19Sl-1970
and 1969-1988, respectively.
Nevertheless,
neither study provided
predictive
evidence
in a holdout
sample,3 and there are
Consider
X,( I - B) = tu,(l -
H,B) .
or
v(a,,a,)
= 0, for all
f # s.
If 0, = 0. the stochastic
process is a random walk. Alternatively.
if H, = 1. the stochastic
process is strictly meanreverting.
Penman (lYY2a) shows that the extent of mean
reversion
can hc inferred by using price to earnings ratios
and price to book value ratios.
Each study estimated the autoregressive
parameters
in two
2%year periods,
hut neither examined
whether
the firmspecific parameter
estimate in the first period yielded more
accurate
forecasts than the random walk predictions
in the
second period.
numerous
ways to generate
a more accurate
annual earnings
forecast than the random walk
IMA (1 ,l) or (autoregressive)
AR (1) models,
by expanding
the information
set beyond
the
time-series
of past annual
earnings
numbers.
This literature
is discussed below.
2.2. Expunding
the information
set upon which
unnuul earnings expectations
are conditioned
Hopwood
et al. ( 1982) showed that the three
ARIMA
quarterly
earnings
time-series
models
can be used to improve the predictive
accuracy
of the annual earnings number.
More specitically, prior to observing the first interim (quarterly)
earnings
report of the fiscal year, one can use
these ARIMA
models to forecast the individual
quarterly
earnings
numbers
which, when summcd, equal an annual earnings forecast which is
1521%
more accurate
than is obtainable
by
extrapolating
from the firms past annual earnings numbers
alone. Hopwood
et al. define the
relative predictive
accuracy of the annual versus
quarterly
models as:
$, (F,,
- Actual, ),/$,
(Fo, - Actual,)
Research
has provided
insights into the process by which analysts formulate
their earnings
expectations.
Some studies have examined
why
analysts earnings
forecasts
are relatively
more
accurate than those made by time-series
models.
Brown and Zmijewski
(1987) show that the anal-
formation
variables.
Using firm size, the homogeneity of analysts earnings expectations
and the
number
of lines of business
(LOB),
as proxies
for the
amount,
precision,
and correlation
among the information
variables,
respectively,
Brown
et al. (1987~) show that the analysts
relative advantage
in forecasting
annual earnings
is positively
related to firm size and the homogeneity of analysts expectations.
Finding no relation
between
the analysts
relative
earnings
forecasting
advantage
and the number of LOB,
they suggest that the number
of LOB is too
crude a proxy for the correlation
among the
information
variables to allow for definitive findings. Their reasoning is as follows: Suppose that
(analysts
possess) tz information
signals (which)
relate to m lines of business. If m is small, the n
information
will
be
highly
corsignals
related.
. if wz is large and each of the n information
signals is randomly
assigned to one of
the m lines of business, the II information
signals
will tend to represent
more diverse types of
information.
This argument
is not very persuasive, as there is no reason to believe that each of
the y1 information
signals is randomly assigned to
one of the m lines of business.
Employing
Value Line quarterly
forecasts,
Kross et al. (1990) also use the number of LOB
to proxy for the correlation
variable and find it
to lack explanatory
power. One explanation
for
the poor LOB results is that the variable
is
significantly
correlated
with firm size and the
homogeneity
of analysts expectations
[Brown et
al. (1987c), p. 601. Another
explanation
for the
poor LOB results is that the correlation
among
the information
variables
is not an important
determinant
of analyst
forecast
superiority.
Nevertheless,
Branson
and Pagach (1993) show
that the Value Line analysts predictive
advantage vis-a-vis the Brown-Rozeff
(1Y79a) model.
is significantly
positively related to LOB for twoand three- (but not one) quarters-ahead
forecast
horizons.
Additional
research is needed to determine whether the Brown et al. (1987~) theory
is poorly specified, the number of LOB is a poor
proxy for the correlation
variable,
or both.
Kross et al. (1990) show that the analysts
advantage
in forecasting
annual
earnings
increases with the firms earnings
variability
and
the amount of coverage by the Wull Street Journal. This provides
additional
evidence that anal-
L.
D. Brown
I Earnings forecmting
reseurch
301
It~~~e.rrmet~/
Zacks
Investment
date.
week
lb-
approximately
Sur,ry
(1091)
ducing idiosyncratic
error. studies finding evidence consistent
with the aggregation
principle
[Ashton
and Ashton
(19X5), Libby and Blashheld (1978).
Winkler
and Makridakis
(1983)]
examined
equally recent forecasts.
Analysts
earnings
forecasts
are not usually
equally
recent.
They
make
their
forecasts
throughout
the year, rather than at any set time,
such as on earnings
announcement
dates. As
some forecasts included in the consensus may be
more than 6 months old [OBrien (19X8)]. the
analyst ignores two quarterly
earnings
reports.
Since analysts
earnings
forecasts
can bc improved simply by substituting
in known quarterly
earnings
numbers
for their previous
expected
values, leaving intact forecasts for the remainder
of the year [Brown
and Rozeff
(1979c)].
it
should
be possible
to improve
analysts
consensus forecasts by deleting old estimates.
Brown
(1991) shows that earnings
forecast
accuracy
can be improved
by discarding
old
earnings
forecasts.
Using detail Zacks Investment Research
data, Brown finds that each of
three *timely composites
(i.e. the most recent
forecast,
an average of the three most recent
forecasts and the 30-day average) is more accurate than the mean forecast. Moreover,
the comparative advantage
of each timely composite depends on firm size; the most recent forecast is
approximately
as accurate as the 30-day average
for small firms, but the 30-day average is significantly
more accurate
than the most recent
forecast
for large firms. These results can be
interpreted
as follows. The aggregation
principle
pertains
to the 30-day average
of large firms
because these firms are followed by many analysts. In contrast, small firms are followed by few
analysts
and even fewer analysts
make their
earnings forecasts within 30 days of each other.
Browns
results
suggest
that the aggregation
principle pertains to earnings forecasts which arc
equally timely, but not to those made at different
points of time.
Several studies have examined
if there exists a
superior
analyst. Using a small sample of Value
Line
earnings
forecasts,
Brown
and Rozeff
(1980) conclude
that superior forecast ability is
before
made on the
the
Vuluc
Lirw
directly
following
the
firm.
positively
correlated
examine
However.
the number
of analysts
analyst hollowing
is highly
not evident.
Using a much larger sample of
I/B /E/S data and a more powerful methodology, OBrien (1990) reaches the same conclusion.
However,
Stickel (1992) uses a large sample of
Zacks Investment
Research
data and concludes
that members
of the Institutional Investor All
American
Research Team are superior earnings
forecasters.
Unlike
OBrien
(1990), he uses a
matched
pair design which fully controls
for
forecast
recency.
Using I/B/E/S
data and a
more powerful control for forecast recency than
OBrien (1990) and Sinha et al. (1993) conclude
that superior analysts do exist.
Using detail Zacks Investment
Research data,
Stickel (1990) shows that analysts annual earnings forecasts can be improved by updating them
with publicly
available
data.
Indeed,
Stickel
(1993) demonstrates
that these updated forecasts
are more accurate than those of the three timely
composites
examined
by Brown (1991). Thus,
the aggregation
principle
pertains
to earnings
which are made at different points in time, provided that they are updated with publicly available data.
In summary,
there are numerous
ways to improve analysts
earnings
forecasts,
such as by
pooling them with time-series
model forecasts,
stock prices, or financial statement
data. Consensus estimates
can be improved
by discarding
old forecasts and by including updated forecasts
in the consensus.
Analysts
do not appear
to
process publicly available information
efficiently
and there appears to be some difference in their
abilities
to forecast earnings.
Why analysts do
not process information
efficiently
and what is
the nature of the information
they underweight/
overweight
are interesting
topics
for future
research.
2.5.
Biases in analysts
earnings
forecasts
optimism
or pessimism to persist over time and
that the degree of persistence
is independent
of
the level of the firms earnings predictability
(as
defined by Value Lines earnings
predictability
ranking).
Biddle and Ricks (1988) show that
analysts
were overly optimistic
regarding
the
earnings
of firms that adopted
last-in-first-out
(LIFO) in 1974. All of these studies suggest that
analysts
may intentionally
generate
optimistic
forecasts.
However,
Affleck-Graves
et al.
(1990) show that disinterested
judges exhibit
significant
optimistic
biases. This suggests that
analysts biases may be attributable
to judgmental heuristics
employed
in earnings
per share
predictions,
and thus are, partly, unintentional.
Sell-side analysts are more optimistic when the
firms they work for either underwrite
the securities of the companies
whose earnings
they
estimate
[Lin and McNichols
(1991)] or act as
the companies
investment
bankers
[Dugar and
Nathan (1992)]. Sell-side analysts are employed
by brokerage
Firms and their forecasts are reported
externally.
Buy-side
analysts
are employed by banks. insurance
companies
and pension funds, and their forecasts are used internally
by the firms portfolio managers.
Sell-side analysts are relatively
more likely to possess an
optimistic bias because they are paid, in part, by
the amount of commissions
they generate [Dorfman (1991)]. It is much easier to get clients to
buy stocks than to sell them (especially to convince clients to short-sell
stocks they do not
own). Moreover,
if the firms that employ them
underwrite
securities or act as the firms investment bankers,
sell-side analysts have additional
incentives
to provide optimistic
forecasts so as
not to upset their firms clients [Siconolh (1992)].
Dugar and Nathan (1992) show that the stock
market
is aware of and adjusts for this bias.
However,
they do not determine
whether
the
adjustment
is complete,
so it is unclear whether
capital markets fully extract the bias.
Francis and Philbrick (1992) show that Value
Line analysts are overly optimistic, in spite of the
fact that Value Line Inc. neither
underwrites
securities
nor provides investment
banking
ser-
Alternative
interpretations
of the evidence
are that the
testing methodologies
lack sufficient
power or improper
assumptions
are made regarding
market
efficiency
(e.g.
zero information
acquistion.
dissemination
and processing
costs).
Fried
and
Forecaster
l/B/E/S
and Poors
Forecaster.
2.6.
Modeling
analyst
following
of forecast
forecusring
research
305
Wiedman
made more
&dines
casts.
USC\ I/R/E/S
than 2 months
a consensus
detail
prior
data,
discards
forecasts
to the quarter-end
and
forc-
which is generally
employed.
Additional
restarch
is needed to determine
which of these
scenarios
is the most descriptively
valid.
3.2. Past quarterly earnings numbers
eurnings unnouncement
drift
and post-
The concept
of post-earnings
announcement
drift has a long history in accounting
and finance
literature
[Ball and Brown (1968), Joy et al.
(1977), Watts (197X). Foster et al. (1984)]. Ball
and Brown showed that stock-price
movements
after annual earnings announcements
are in the
same direction
as consecutive
annual
earnings
changes.
Thus. if annual earnings
in year t exceed, or fall short of, those of year t - 1. stock
prices move up. or down, after year t earnings
arc announced.
Stock-price
movements
after
year t earnings
are announced
are known as
post-earnings
announcement
drift. Rendleman
et
al. ( 1987) showed that stock prices fail to capture
fully the implications
of current quarterly
earnings for future earnings.
Observing
significantly
positive adjacent yuartcrly autocorrelations.
they
argued that investors fail to recognize the implications of quarter
t earnings
for quarter
t+ 1
earnings.
Bernard
and
Thomas
(1990)
extend
the
Rendlcman
et al. analysis by incorporating
implications of quarter t earnings for quarter t + 1 to
t + 4 earnings.
They show that the 3-day stockprice reaction around the time of quarterly earnings reports
is predictable,
conditional
upon
knowledge
of the past four quarterly
earnings
numbers.
More specifically. they argue that stock
prices erroneously
act as if quarterly
earnings
follow a seasonal random walk with drift model,
in fact, quarterly
earnings
follow the
when.
(011) x (011) Box-Jenkins
ARIMA process [i.e.
the model
suggested
by Brown
and Rozeff
( 1979a)] Thus. stock prices mistakenly
behave
as if the current quarterly
earnings shock has a
positive impact on earnings four quarters hence.
I ~lheconventional
ing.
generating
explanations
definition
and processing
information.
better
association
both dimensions
included
than tither
in the study.
dimensions
Alternative
than model B on
includc:
defined:
ac-
mod-
model C is better
on
ly earnings generating
process appears to violate
semi-strong
market
efficiency
[Fama
(1970)).
Whether
the anomaly
occurs, and, if so, why,
are interesting
topics for future research.
3.3. Analyst behavior and post-eurnings
announcement drift
Mcndenhall
(1991) shows that: (I) analysts
underestimate
the serial correlation
in quarterly
earnings,
(2) investors
use analysts
earnings
forecast revisions to reassess the persistence
of
their previous
forecast errors and (3) investors
systematically
underestimate
the persistence
of
their previous
forecast
errors.
Assuming
that
stock prices capture security analysts earnings
expectations,
Mendenhalls
results are consistent
with those of Bernard and Thomas.
Similar
to Mendenhalls
results
regarding
quarterly earnings, but in contrast with an earlier
study of annual earnings by Givoly (1985), Ali et
al. (1992) find that analysts generally
underestimate the permanence
of the current annual earnings surprise
with regard
to future
annual
earnings. More specifically,
Ali et al. show that
analysts generally are overly optimistic regarding
the subsequent
years annual earnings and that
their annual earnings forecast errors display significantly
positive
serial
correlation.
Givoly
found analysts forecasts to be unbiased and their
prediction
errors
to be serially
uncorrelated.
However,
his sample is much smaller than that
of Ali et al. (i.e. Givolys results were based on
as few as 378 firm-years; Ali et al.s findings were
based on 3184-5305
firm-years).
The latter rcsults appear to be relatively more credible. given
the studys larger sample and more powerful
methodology.
Using Value Line data, Abarbanell
and Ber Stock prices do not fully capture
analysts expectations,
but the degree of proximity
should be close enough to
make the Mendenhall
(IYYI) and Bernard
and Thomas
(1989. 1990) results reasonably
consistent with each other.
As evidence that stock prices do not fully capture analysts
expectations,
see Ahdel-khalik
and Ajinkya
(1982) and
Elton et al. (1981).
who show that analysts
forecast
revisions led stock price changes. Their respective sources
of analyst forecasts are Merrill Lynchs Option Alerr and
I/B/E/S
consensus
data.
Mendenhall
u5es
Value Line data; Givolv uses Standard
and Poors Eurnings Forecaster detail data; Ali et al. use
I/B/E/S
consensus
(median) data.
L, D. Rrown
Zacks
access
search
I Earnings forecurting
Investment
Research now have increased
to these data, it is likely that future rewill rely more on individual
analyst data.
returns
Elton et al. (1981) provide evidence that investors cannot earn abnormal
returns by selecting stocks based on analysts consensus
growth
forecasts.
In contrast,
Givoly and Lakonishok
(1979), Abdel-khalik
and Ajinkya (1982), Hawkins et al. (1984), Freeman and Tse (1989), and
Beneish (1991) show that consensus analyst forecast revisions can bc used to predict subsequent
A potential
reason for the
abnormal
returns.
discrepancy
is that Elton et al. did not examine
forecast
revisions.
It would be instructive
to
investigate
whether
this is the reason for the
discrepancy
in results between
Elton et al. and
the other studies,
and if larger profits can be
made by using timely analysts forecasts,
those
pooled with time-series
model forecasts and/or
those
updated
using the Stickel (1990) procedure.
It also would
be interesting
to determine
whether
larger profits can be made by using
timely, or updated,
analyst estimates
in lieu of
the consensus estimate. Stickels (1991) evidence
may be instructive
in this regard. Showing that
the analysts
current
outstanding
forecast
is a
better measure of the markets earnings expectation, in the association
dimension,
than is an
updated forecast,
he uses this result to create a
profitable
trading strategy that predicts changes
in outstanding
forecasts.
Additional
research is
needed to reveal how and why analyst expectational data can be used to produce
abnormal
returns.
4. Earnings
4.1.
response
coefficient
literature
rc~earch
309
in accounting
earnings
to abnormal
stock returns [Easton and Zmijewski
(1989)]. The ERC
directly
links earnings
forecasting
research
to
capital markets
research because the definition
of earnings surprise is conditional
upon an earnings expectations
model. ERC studies often require a proxy for the earnings persistence
factor,
which relates changes in expected future earnings to current
earnings
surprise,
because,
in
theory, the valuation
implication
of an earnings
number
(the ERC) is positively
related to its
degree of permanence
(the earnings persistence
parameter).
Studies have not been uniform regarding the ARIMA
model chosen to estimate
the earnings persistence
parameter.
Some of the
assumed
ARIMA
models and their advocates
are: ARIMA
(O,l,l)
[Beaver
et al. (1980)],
ARIMA
(0,O.l)
[Miller
and
Rock
(1985)].
ARIMA
(2,1,(l) [Kormendi
and Lipe (1987)],
and
ARIMA
(1 ,O,O) [Ramakrishnan
and
Thomas
( 1992)].15 Surprisingly,
little work has
been done examining
the sensitivity
of ERC
estimates to alternative
ARIMA model specifcations. [See Kendall and Zarowin (1990) for some
limited
evidence
on this issue.] The external
validity of this research would be enhanced
(or
lessened)
considerably
by showing that the results are (or are not) robust
to alternative
ARIMA
model specifications.
Easton and Zmijewski
argue that the analysts
earnings
revision coefficient
(i.e. the coefficient
relating current earnings to analysts estimates of
future earnings)
is an explanatory
variable
of
ERC. They document
a positive association
betwecn the ERC and the analysts earnings revision coefficient,
and a negative association
be If earnings
can be modclled
as an AROMA process and
changes
in expectations
about future earnings
produce
dollar for dollar changes
in expectations
about future
dividends,
Flavin (1081) shows that the theoretical
ERC is
(I + persistence factor) where the persistence factor is:
The earnings
efficient relating
response
coefficient
is the cothe surprise (new information)
Elton
where 4, is an autoregressive
coefficient
moving average
coefficient
of order i;
orders
of the autoregressive
process,
moving average processes,
respectively;
of capital.
of order C; 0, is a
p. d and q arc
differencing
and
R is 1 + the cost
studies modeling
ERCs are robust to ERC estimates incorporating
timely earnings
forecasts.
lagged quarterly
earnings,
revisions
of future
quarterly
earnings
and alternative
specifications
of the earnings
time-series
process.
4.2.
Determinants of ERG
Collins
and Kothari
(1989) find that ERG
increase in economic
growth and/or time-series
persistence
[Kormendi
and Lipe (1987)],
and
decrease
in interest rates and risk. Lipe (1990)
shows that the ERC is positively related to both
the predictability
of the earnings series and the
time-series
persistence
of earnings. The forecasting literature
as it pertains
to the time-series
properties
of earnings
is relevant to the Collins
and Kothari
(1989) and Lipe (1990) studies.
These studies, respectively,
assume, but do not
test, that the time-series
process of annual earnings follow an ARIMA
(O,l,l)
[Beaver et al.
( 19SO)] and ARIMA
(2,l .O) [ Kormendi
and
Lipe (1987)] process. However,
Lipe and Kormendi (1993) show that annual earnings follow a
fourth-order
autoregressive
process and that a
dollar of year t earnings
surprise
leads to an
approximately
8O-cent revision
in year t + 1
earnings.
The robustness
of the Collins and
Kothari (1989) and Lipc (1990) results to alternative definitions
of earnings persistence.
such as
the one advocated
by Lipe and Kormendi
(1993), awaits further research.
Brown and Zmijewski
(1987) find that ERCs
are smaller during strikes than at other times.
This finding is consistent
with the joint hypothesis that price-irrelevant
and transitory
earnings
are higher during strikes, and that the capital
market assigns a smaller multiplier to these earnings components
[Ramakrishnan
and Thomas
(1991)]. Collins and DeAngelo
(1990) find ERCs
to be higher during proxy contests
and lower
after proxy contests than at other times. They
consider the former result as surprising,
because
earnings
management
during
proxy
contests
should lower ERCs and the latter result as con Lipe and Kormendi consider the general ARIMA ( p,d,q)
model. set tl = I, q = 0. and focus on the effects of changing /7. the order of the ARIMA
(p.1.0) t~~odel.They
cstimnted
the parameters
for the first through tenth orderh. but found most of the improvements
to occur hy the
fourth order.
L. D. Brown
i Earnings
form
of the ERC
(199(l),
estimation
and
forecasting
research
311
Freeman
and Tse (1992) show that the relation
between abnormal
returns and unexpected
earnings is non-linear.
Abdel-khalik
(1990) shows
that a mode1 relating
abnormal
returns to unexpected earnings is better specified if it includes
the past and future revisions of earnings expectations in the estimation
equation.
Das and Lev
(1991) show that the non-parametric
procedure,
locally weighted
regression,
yields significantly
more explanatory
power
than ordinary
least
squares
(OLS) in an abnormal
return on unexpected earnings regression,
especially for small
earnings
surprises.
Freeman
and Tse (1992)
show that the marginal response of stock price to
unexpected
earnings
declines
as the absolute
value of unexpected
earnings increases.
Assuming that the absolute value of unexpected
earnings is negatively
related to earnings persistence
and that it is relatively easier to forecast permanent
earnings
than transitory
earnings,
they
maintain
that these two assumptions
imply that
transitory
earnings surprises are concentrated
in
the tails of the unexpected
earnings distribution.
Their evidence
is consistent
with the view that
the earnings-return
relation
is S-shaped
(i.e.
convex
for bad news and concave
for good
news).
Cheng et al. (1992) evaluate the specification
of the commonly
used method of estimating
the
ERC, namely
a linear regression
of abnormal
returns
on unexpected
earnings.
They include
three samples of earnings forecasts - the random walk mode1 forecast
and two sources of
analyst forecasts,
I/B/E/S
and Value Line and examine returns for both short (2-day) and
long (more than 1 year) event windows. Testing
for non-linearity,
heteroscedasticity,
residual
non-normality,
omitted variables and coefficient
variation
across firms, they generally
reject the
classical normal linear regression
model assumption (i.e. in almost all cases, they find the relation to be non-linear).
The Cheng et al. (1992)
and Freeman and Tse (1992) studies suggest that
ERC estimation
models based on the linearity
assumption
are misspecified
and may lead to
inconsistent
inferences.
Cheng et al. replicate
Cornell and Landsman
(1989), and find that the
specification
problems are severe enough to lead
to substantial
instability
in the linear regression
models inferences.
Their OLS analysis of Cornell and Landsmans
data revealed
problems
with heteroscedasticity,
non-linearity
and nonnormality.
The model with the ranked forecast
errors (the Cheng et al. approach)
produced
a
considerably
higher degree of coefficient stability, R, and larger t-values than the conventional,
unranked
forecast error approach
(used by Corncll and Landsman).
In contrast with Abdel-khalik
(19SO), Das and
Lev (1991) and Freeman
and Tse (1992), who
conduct
cross-sectional
and in-sample
analyses,
Beneish
and Harvey
(1993) conduct
temporal
and cross-sectional
analyses,
and provide fitting
and predictive
evidence.
Their temporal
and
cross-sectional
analyses
on seven models (one
linear. four non-linear
and two non-parametric)
suggest
that linear
models
arc inferior
when
using in-sample
data, but not when using out-ofsample data. Providing evidence that some of the
non-linear
models overfit the data. they suggest
that temporal
and cross-sectional
ERC changes
should be identified
with a methodology
that is
robust to influential
observations
(c.g. adaptive
non-parametric
regression).
Mendenhall
and Nichols (1988) find the ERC
response to bad-news earnings to depend on the
announcements
fiscal quarter. More specifically,
the ERC is greater for interim than for annual
(fourth
quarter)
reports.
Their results suggest
that ERC models should allow for differential
rcsponscs
to bad news for interim versus annual
earnings announcements.
However. their empirical tests arc incomplete
as they exclude goodnews earnings
[Palcpu (1%X)]. Additional
theoretical
development
and empirical
tests are
necessary
before definitive
conclusions
can be
drawn
Ohlson
(lC)Yla,b)
and Ohlson
and Shroff
(1992) argue that earnings levels, deflated by the
beginning-of-period
price, often arc more appropriate
than
are
properly
deflated
earnings
changes as proxies for unexpected
earnings when
modeling
rates of return.
Easton
and Harris
(1901) and Ali and Zarowin
(1992) use long
windows
(12-month
returns).
and provide cvidence consistent
with these models. Their tindings suggest
that long-window
ERC
studies
should include earnings
levels to appropriately
estimate
ERCs.
E&ton and Harris
earnings
Y.,lhfi,3/P,,
introduce
a multivariate
analysis
ot
expectutions
md
earnings
eqectations
Bandyopadhyay
et al. (1993) examine whether
analysts incorporate
their earnings forecasts into
their stock-price forecasts and if the usefulness of
analysts earnings
forecasts for their stock-price
forecasts
is related to the length of their joint
stock price to earnings
forecast horizon.
They
show that analysts act as if earnings forecasts are
over
the
months
earnings
I2 months
after
extending
9 months
annual
from
I : E,,is
random
I: I,,
prior
to 3
accounting
,,
price pel-
error of firm j at
important
for their stock-price forecasts and that
earnings
are relatively more important
for price
in the longer term. Their finding that long-term
ex ante ERCs arc relatively greater than shortterm ex ante ERCs is consistent with Lev (1989),
Kothari and Sloan (1992), and Ohlson and Penman (1992), who show that long-term
ex post
ERCs
are relatively
greater
than short-term
ones. (Ex ante ERC studies relate expected returns to expected earnings;
cx post ERC studies
relate actual returns to actual earnings.)
There are two factors at work regarding
the
relation between the ERC and the length of the
horizon.
On the one hand, GAAP conservatism
suggests a higher ERC when the joint earnings
and price horizon is lengthened
because cumulated reported
earnings
include relatively
more
of what is impounded
in price. On the other
hand, the ERC over the life of the firm (birth to
death) is 1.0. As a longer horizon is more akin
to the life of the firm, the ERC may be smaller
over a longer horizon (i.e. it may approach
1.0
asymptotically
from above).
Consistent
with
Levs (1989) argument
that GAAP conservatism
in measuring
earnings causes stock prices to lead
accounting
earnings,
the Bandyopadhyay
et al.
(1993) evidence
suggests that non-earnings
information
is relatively
more
important
for
shorter-term
price estimates.
However,
Bandyopadhyay
et al. (1993) are silent regarding the
nature of the non-earnings
information,
and they
do not say how analysts stock-price
forecasts,
earnings forecasts and non-earnings
forecasts relate to the capital markets expectation
of these
variables.
Govindarajan
(1980) uses content analysis to
examine
the importance
given by security analysts to earnings
versus cash flows when they
make their recommendations.
Security analysts
comments
on companies
in 976 reports were
scrutinized
using the Wall Street Transcript, and
rated from one to six, according to the authors
interpretation
of the commentary,
as follows: (1)
no mention
of earnings,
(2) earnings analysis is
less important
than cash flow analysis, (3) earnings analysis and cash flow analysis are equally
important,
(4) earnings
analysis
is more important
than cash flow analysis,
(5) earnings
analysis only, except for mention
of dividends
and (6) no mention of cash flows. Security analysts attached more weight to earnings than cash
The relation
hetwcen
post-earnings
announcement
drift
and the rapidity of convergence
of analysts expectations
is
best examined for positive earnings surprises. Stock prices
should he lower when uncertainty
is heightened
[Vxian
(19X5)], unconditional
on the sign of the earnings surprise.
Thus. stock prices should drift upwards
after earnings
announcement
drift for both good news and bad news. An
increase
in stock prices owing to uncertainty
resolution
may provide an explanation
for positive earnings surprises
being followed by positive drift.
financial statement
analysis can be used to detect
mispricing.
[Lev and Thiagarajan
(19YI), Penman (1992~). and others have recently advocated
a return
to fundamentals.]
Such research
should examine how (and why) analysts use (and
ignore) certain financial statement
data.
The manner
in which analysts
use/neglect
earnings
and non-earnings
information
is crucial
for a better understanding
of how stock prices
are formulated.
If capital markets
are not informationally
efficient, it is important
to understand how analysts
process earnings
and. nonearnings
information
to estimate intrinsic value,
which is not necessarily
impounded
in stock
price. Behavioral
research,
which has played a
limited role to date in understanding
how analysts formulate
their expectations,
is likely to play
a more prominent
role in the future.
6. Implications
areas
for forecasting
research
in other
L. D. Brown
31s
information
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