Randall Mann
Research Proposal
10/28/11
“How do Earnings Projections Affect Companies’ Stock Prices?”
This paper will study the effects of consensus earnings projections on stock prices. In
particular, the paper will seek to analyze the “surprise factor” of earnings announcements. This
surprise factor is when a company reports earnings higher or lower than the consensus estimates.
Stock prices typically drop immediately after an earnings miss, but there are many aspects that
could be studied about these situations. Possible left-hand variables could be the magnitude of
the drop or the time it takes for the price to recover. There are many explanatory variables to be
used, including: the company’s size, industry, overall macroeconomic climate, whether the
magnitude of the earnings miss, whether the company has a history of earnings misses, whether
the earnings projections were higher or lower than previous years, etc. There is an ample amount
of data to answer these questions, as historical stock prices and financial data are public
information. Bloomberg, which is available in the library, allows for queries of all the historical
data that would be required for this paper. This source will allow for a large dataset, which
should improve the results of the paper.
There is a great deal of literature on stock prices, but not as much on earnings projections.
One previous study looked at the effects of analyst recommendations (buy, sell, hold) on stock
prices, with the conclusion that they have relatively little effect. Another paper studied the effect
of dividend announcements on bank stocks, with the conclusions that such announcements do
not have much of an impact on the stock price. While these papers will provide good perspective
on some of the issues surrounding the topic, it appears that the effects of earnings misses has not
been studied.
Another topic I hope to incorporate into the paper is expectations theory. Most investors
view equity value as the total future free cash flows of the company, discounted to the present
(Discounted Cash Flow Model). In these models, earnings play a large role in predicting the
value of a stock. Therefore, when information that contradicts the previous expectations
becomes available (earnings misses), investors must adjust their expectations of future cash
flows and revalue the stock. This hypothesis would allow economic expectations theory to
explain the movement of stock prices in the days following quarterly earnings announcements.
Some papers have found that adaptive expectations provide a better fit for stock prices than
rational expectations. I hope to create a unique model that can test both
Preliminary sources and abstracts:
Rational Versus Adaptive Expectations in Present Value Models
Author: Gregory C. Chow. Published in: The Review of Economics and Statistics, Vol. 71, No.
3 (Aug., 1989), pp. 376-384
“Using data on stock price and dividends, and on long-term and short-term interest rates, we test
an important implication of present value models, that current value is a linear function of the
conditional expectations of the next period value and the current determining variable. This
implication, combined with rational expectations RE, is strongly rejected. Combined with
adaptive expectations AE, it is accepted. The latter model can also explain the observed negative
relation between the rate of return and stock price. Thus the
RE assumption should be used with caution; the AE assumption may be useful in econometric
practice.”
An Analysis of Earnings per Share Forecasts for Stocks Listed on the Stockholm Stock
Exchange
Author: Eva Liljeblom. Published in: The Scandinavian Journal of Economics, Vol. 91, No. 3
(Sep., 1989), pp. 565-581
“This paper focuses on the information conveyed by financial analysts' earnings per share
forecasts for publicly traded stocks. The results provide evidence of good predictive power,
especially for short forecast horizons of one and three months. Observations of stock price
reactions to the publication of these forecasts indicate that the forecasts mostly reflect
information already known by the market. However, a significant stock price reaction is found
for large changes in EPS forecasts. The stock price reaction in such cases usually occurs
immediately after publication and is generally not large enough to produce profit opportunities,
even for investors who have prior knowledge of the forecasts.”
“When Are Analyst Recommendation Changes Influential?”
Author: Loh, Roger. Published in: Review of Financial Studies, v. 24 no. 2, pp. 593- 627 Date:
2011-02
“The existing literature measures the contribution of analyst recommendation changes using
average stock-price reactions. With such an approach, recommendation changes can
have a significant impact even if no recommendation has a visible stock-price impact. Instead,
we call a recommendation change influential only if it affects the stock price of
the affected firm visibly. We show that only 12% of recommendation changes are influential.
Recommendation changes are more likely to be influential if they are from leader,
star, previously influential analysts, issued away from consensus, accompanied by earnings
forecasts, and issued on growth, small, high institutional ownership, or high forecast
dispersion firms.”
“An Empirical Event Study on Possibilities to Earn Superior Risk Adjusted Returns of
Selected Stocks by Trading on Earning Announcements”
Author: Jayaraman, R. Published in: Indian Journal of Finance, v. 5 no. 2, pp. 10- 14 Date:
2011-02
“The efficient performance of a particular stock in the market can be measured in several ways
and means. The capital gain of a stock will be the major determinant of the performance of a
stock. Any stock, which generates more quantum of capital gain, that stock is considered to be
the efficient stock? If any market, which possesses efficient stocks, that market is considered to
be the efficient market. In other words, an efficient market is one in which the market price of a
security is an unbiased estimate of its intrinsic value. Market efficiency is defined in relation to
information that is reflected in security prices. Market efficiency can be segregated into three
levels--they are weak-form efficiency, semi-strong-form efficiency and strong-form efficiency.
In the weak-form efficiency, the prices of a stock reflect all information found in the record of
past prices and volumes. Whereas in the semi-strong-form efficiency, the prices of a particular
stock reflect not only all information found in the record of past prices and volumes, but also all
other publicly available information. In the strong-form efficiency, the stock prices reflect all
available information, public as well as private. This paper focuses on the semi-strong-form
efficiency of SBI and HDFC bank stocks. So, to examine the semi-strong-form efficiency of SBI
and HDFC bank stocks, the Rate of return of the selected stocks were taken for fifteen days from
the date of announcement of dividend and the run test was applied separately and together on the
Rate of returns of the selected bank stocks. The result shows that there is no impact of
announcement of dividend over the rate of return of State Bank of India and HDFC Bank stocks
from the date of declaration of dividend.”