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					                                                                                         July 26, 2007




    Why Has the Market Reaction to Corporate Earnings
         Announcements Increased over Time?*

                                            Christo Pirinsky

                                                  and

                                             Qinghai Wang




*
  Christo Pirinsky is from the College of Business and Economics, California State University, Fullerton,
2600 E. Nutwood; Suite 1060, Fullerton, CA 92831 and Qinghai Wang is from the School of Business
Administration, University of Wisconsin – Milwaukee, Milwaukee, WI 53201. Pirinsky can be reached at
714-278-2217 or cpirinsky@fullerton.edu; Wang can be reached at 414-229-4775 or wangq@uwm.edu. We
thank Shmuel Baruch, Valentin Dimitrov, Simi Kedia, Feng Zhao and seminar participants at Rutgers
University for helpful comments.
  Why Has the Market Reaction to Corporate Earnings Announcements Increased
                                 Over Time?

                                             Abstract


Stock price reactions to earnings announcements have been increasing over the last three decades,

while at the same time the usefulness of reported earnings information to investors has been

deteriorating. To reconcile these two findings, we propose an explanation that relates the value of

new information (and hence its price impact) to both the precision of the information signal as well

as the uncertainty of underlying fundamentals. In a world of more uncertain fundamentals, prices

will react more at information releases since the new information would resolve more uncertainty.

We confirm this hypothesis by showing that measures of the average cash-flow uncertainty in the

market can explain the up-ward trend in stock price reactions at earnings announcements.



JEL classification: G14; G20

Keywords: Earnings announcement, stock price reaction, asset pricing




                                                 2
         Stock return volatility around earnings announcements has increased substantially over the

last three decades (see Landsman and Maydew (2002)). This trend has been recognized not only by

academic researchers but also by corporate executives and financial market regulators. A recent

Associated Press report states that “[q]uarterly earnings announcements look more than ever like

prize fights: hyped events that often leave the pugilists battered and the fans drained.”1 Many

corporate executives consider stock price reactions at earnings announcements excessive and have

attempted to distance investors from quarterly earnings information. In the same report, the

Washington Post Chairman and CEO Donald Graham comments “We don’t do quarters. Quarterly

earnings are not in the top 100 things you should care about if you want to value the company. ... If

you care about that sort of thing, you shouldn't own our stock.”

         The upward trend in earnings-related return volatility seems surprising given that the

relative importance of earnings has actually decreased over time. For example, Ely and Waymire

(1999), Francis and Schipper (1999) and Lev and Zarowin (1999) find that the usefulness of

reported earnings, cash flows, and book (equity) values to investors has been deteriorating over

time. They argue that this trend is largely driven by the increase in the amount and quality of

alternative investment information in the market.2 The last few decades have seen tremendous

growth of the security analysis industry and numerous financial innovations, all of which facilitate

the extraction of information from firms prior to earnings announcements. As a result, one would

expect stock price volatility at earnings announcement to decrease over time. Thus, the stronger

stock price reaction at earnings announcements seems difficult to reconcile with the declining value

of earnings information.

1
  See “Should We Hear From Companies More Often Than Four Times a Year?” by Ellen Simon , July 22,
2005, Associated Press.
2
  Ryan and Zarowin (2003) also show that earnings increasingly reflect news with a lag relative to stock
prices, which implies that the relative importance of earnings relative to non-announcement information
tends to decrease over time. Kim and Kross (2005), however, show that the ability of earnings in predicting
future operating cash flows has been increasing, suggesting that earnings information is not less valuable for
predicting future earnings.




                                                      1
        The underlying reasons for the upward trend in earnings-related stock return volatility are

still unclear. Most of the proposed explanations relate stock price reactions at earnings

announcements to the patterns of information disclosure by firms. For example, Francis, Schipper,

and Vincent (2002a) argue that the increase in earnings announcement return volatility could be

explained by the recent increase in concurrent disclosures by companies around earnings

announcements. In a related vein, Collins, Li and Xie (2005) argue that the recent increase in return

volatility around earnings announcements is caused by stronger price reactions to “Street” earnings

(i.e., I/B/E/S reported actual earnings), in comparison to weaker reactions to GAAP earnings.

Another view relates the magnitude of earnings-announcement stock returns to the frequency of

disclosure. Along this line, Harvey Pitt, the former chairman of the SEC, suggests in a 2002

Congressional testimony that “[p]ublic companies should be required to make affirmative

disclosures of unquestionably material information in real time, including providing updates to

prior disclosure.”

        In this paper we propose an alternative explanation for the up-ward trend in earnings-

related volatility in the stock market. Within a simple framework, we show that the value of new

information (and hence its price impact) increases in both the precision of the information signal as

well as the uncertainty of underlying fundamentals. Most previous studies elaborate on the first

aspect of earnings announcements, namely the quality of information disclosure. Here we elaborate

on the second one – the uncertainty of firm fundamentals. If the uncertainty of firm fundamentals

has increased over time, than this trend could potentially explain the increased stock price reaction

at earnings announcements. We show that the uncertainty of firm fundamentals, as measured by

earnings volatility, has indeed increased substantially over the last three decades. Consistent with

our conjecture, we also find that the average earnings volatility in the market is able to explain the

time-series trend in the average stock price reactions at earnings announcements.




                                                  2
        We begin our empirical analysis by providing comprehensive evidence on the increasing

price reactions to earnings news over the period of 1978 to 2004. Over the sample period, stock price

reactions to earnings announcements have increased significantly. This increase is uniform for both

positive and negative earnings surprises and for stocks listed on both NYSE and NASDAQ. While

large stocks experience more dramatic increases in return volatility around earnings

announcements, the upward trend is also well pronounced among small stocks.

        We next confirm that both the information production outside of earnings announcements

and the quality of earnings information available prior to earnings announcements have indeed

increased over time. We use financial analysts earnings forecast to measure information production

and quality of earnings information outside of earnings announcements. We show that both the

number of firms covered by financial analysts and the number of analysts covering a firm have

increased substantially over the sample period. More importantly, we find that the uncertainty

surrounding corporate earnings announcements has decreased over time: the magnitude of both

earnings surprises (measured by financial analysts’ forecasts errors) and the uncertainty of earnings

forecasts (measured by dispersion of analyst forecasts) have decreased dramatically over the last

three decades. The down-ward trend in both earnings surprises and analyst forecast uncertainty

suggest that the up-ward trend in stock return volatility around earnings announcements does not

reflect an increased importance of earnings information relative to market expectations.

        Consistent with our predictions, we also show that the uncertainty of underlying firm

fundamentals has increased substantially over the last three decades. We use volatility of quarterly

earnings (volatility of return on equity) to measure uncertainty of firm fundamentals. Results based

on several alternative earnings volatility measures provide consistent evidence on the changing

uncertainty of firm fundamentals. We also show that earnings yields (earnings relative to market




                                                 3
price) decreased significantly over the sample period, suggesting market valuation of corporate

earnings has also increased.

        To examine the link between firm fundamentals and earnings announcement volatility, we

first estimate cross-sectional regressions of absolute earning announcement returns on determinants

of stock return volatility around earnings announcements. The cross-sectional analysis confirms

that, after controlling for earnings surprises and other firm characteristics, firms with more volatile

earnings and firms with lower earnings yields exhibit stronger reactions at earnings

announcements.

        We further implement a direct time-series test of the link between earnings volatility and

stock price reactions around earnings announcements. We regress average absolute earnings-

announcement stock returns on average earnings uncertainty measures over the sample period in a

linear time trend model. We show that earnings volatility is the most important factor explaining

the time-series trend of average stock price reactions around earnings announcements.

        We conclude our empirical analysis by examining whether the increased price reaction to

earnings news is related to changes in investor behavior, particularly investor reactions to earnings

news. Many academic studies have shown that, following earnings announcements, stock prices

continue to drift in the direction of the earnings news (i.e., post-earnings announcement drift). One

common interpretation of this phenomenon is investor underreaction to earnings information (see

Bernard and Thomas (1990)). It is possible that the increased price reaction to earnings news could

be a ‘correction’ of the underreaction phenomenon. If this is the case, we would expect that the

post-earnings announcement drift would weaken (or even disappear) over time. We show,

however, that the magnitude of the post-earnings announcement drift remains unchanged over the

sample period. This suggests the up-ward trend in earnings-related volatility in the market is not

related to changes in investor trading behavior, or arbitrage-trading activities related to earnings




                                                  4
announcements. This result is inconsistent with the claims made by corporate executives that

investor reactions to quarterly earnings news are excessive and lends further support for the

fundamentals-based explanation of the increased volatility around earnings announcements.

        In sum, we find that stock price reactions to earnings announcements have increased

significantly over the last three decades. Consistent with previous studies, we also confirm that the

relative importance of earnings announcements has deteriorated over time. We argue that the up-

ward trend of earnings-related price volatility can be explained by the up-ward trend in the

uncertainty of firm fundamentals. In a world of more uncertain fundamentals, prices will react

more at information releases since information here would resolve more uncertainty.

        Our paper is closely related to the recent finding of Canpbell, Lettau, Malkiel, and Xu

(2001) that the idiosyncratic volatility of stock returns has increased over time. The underlying

reasons for such an increase are controversial. For example, Fink, Fink, Grullon, and Weston

(2005) argue that the effect is driven by the increased propensity of firms to go public earlier in

their life. Wei and Zhang (2005) explain the trend in idiosyncratic volatility with the recent

increase in the volatility of corporate earnings. We show that volatility at earnings announcements

follows strongly this upward trend. Since earnings announcement stock returns represent a

significant fraction of aggregate stock return volatility, our results also shed some light on the

increase of idiosyncratic volatility.

        The paper is organized as follows. Section I documents the time-series trends in earnings

reactions. Section II discusses the basic hypotheses. Section III studies the time-series trends of

earnings informativeness and firm fundamentals. Section IV presents cross-sectional and time-

series analysis on the determinants of price reactions to earnings announcements; and Section V

studies the time-series trends in the post-earnings announcement drift. We conclude in Section VI.




                                                 5
I. Time-series Trends in Earnings Reactions

I.A. Data

        The sample includes stocks listed on the New York Stock Exchange (NYSE), American

Stock Exchange (AMEX), and NASDAQ that appear on the CRSP and COMPUSTAT tapes. The

sample period is from 1978 to 2004; it spans 27 years of the most resent stock market history. We

exclude real estate investment trusts (REITs), American Depository Receipts (ADRs), and closed-

end mutual funds. To mitigate microstructure effects, we also exclude stocks priced below $5 and

stocks in the lowest market capitalization decile based on NYSE breakpoints as of the end of the

previous calendar year.3

        We obtain data on corporate earnings from Compustat quarterly files. Earnings are

measured before extraordinary items and discontinued operations. We use the calendar year and

quarter variable in COMPUSTAT to align quarterly earnings across firms.

        Table I presents the summary statistics for the sample. Our sample has 1,556 stocks in

1978, more than 3,000 stocks in the 90s, and 2,314 stocks at the end of 2004. The analyst coverage

data is from I/B/E/S. I/B/E/S starts reporting analyst quarterly earnings forecast in 1984.4 The

percentage of stocks with analyst coverage in the sample increases steadily over time. While in

1984, the fraction of our sample with analyst coverage was 50 percent, this fraction reaches 97

percent in 2004. The average number of analysts covering a stock also increases from around 4 in

1984 to close to 9 in 2004. The substantial increase in analyst activity over the last 30 years

suggests that the overall amount of earnings-related information in the market has increased as

well.



3
  Another reason for removing the lowest decile firms from the sample is that Compustat earnings
information is largely unavailable for these firms.
4
  I/B/E/S begins reporting annual earning forecast in 1978, but analyst coverage in the late 70’s and early
80’s is generally much lower. Because we study price reactions to quarterly earnings announcements, we use
analyst coverage for quarterly earnings throughout the paper.




                                                     6
           Institutional holdings data originates from the CDA Spectrum 13F Filings database and it

starts in 1980. Under the 1978 amendment to the Securities and Exchange Act of 1934, all

institutional investors managing a portfolio with an investment value of $100 million or more are

required to file quarterly 13F reports to the SEC, listing their equity positions greater than 10,000

shares or $200,000 in market value as of the last date of each quarter. For each stock in the sample,

we calculate the level of institutional ownership using the percentage of shares owned by

institutions relative to total shares outstanding at the end of each quarter. The institutional presence

in the market has also increased substantially over time. While in 1980 the average institutional

ownership in a stock was 21 percent, in 1980 the average institutional ownership in a stock was 60

percent.



I.B. Time Trend of Stock Price Reactions to Earnings News

           We start our analysis by estimating the time-series properties of stock price reactions at

earnings announcements. Our results in this section are consistent with results from previous

studies. Our sample, however, significantly exceeds the samples in most of these studies. For

instance, Landsman and Maydew (2002) conduct their study on 1000 randomly selected stocks,

while Francis, Schipper, and Vincent (2002a)) examine only 400 large stocks. In addition, we also

provide a more detailed look at the trend in earnings-announcement volatility across small and

large stocks, different exchanges, and positive and negative reactions.

           We calculate earnings-announcement stock returns over a three day window (-1, 0, +1)

centered at the earnings announcement date (date 0). Afterwards we subtract from the earnings-

announcement return the corresponding three day return of a portfolio of stocks with similar

market capitalization. The benchmark portfolios are based on NYSE market capitalization deciles




                                                   7
at the end of the previous year. Throughout the paper, we use this excess return to measure stock

price reaction to earnings news.

        For each quarter we calculate equal- and value-weighted averages of the absolute earnings

announcement excess returns. Panel A of Figure 1 presents the time series of the quarterly

averages. We observe a strong upward trend in the average stock price reactions at earnings

announcement dates. The average absolute stock return at earnings announcements has increased

from 2.3 percent at the beginning of 1978 to almost 5 percent at the end of 2004. The equal-

weighted results appear uniformly stronger than the value-weighted results, indicating a size effect

in the reactions.

        Panel B of Figure 1 plots separately the average positive and negative earnings reactions.

We observe that the magnitudes of the positive and negative returns around earnings

announcements are remarkably close. Interestingly, stocks become much more sensitive to earnings

announcements in periods of high market uncertainty, such as the market crash in 1987 and the

burst of the internet bubble in 2000 and 2001. For example the average stock price reaction at the

fourth quarter earnings of 1987 was 6.1 percent and at the fourth quarter earnings of 2000 as high

as 8.3 percent. Note that these responses are not mechanically related to the crash. All price

reactions are already adjusted for the market. The responses are symmetric – present for both

positive and negative returns.

        Figure 2 reports the time series of average stock price reactions for five price reaction

quintiles. Each quarter, we sort stocks into five quintiles based on the excess stock returns over the

three day period (in this case, we do not use absolute values) and calculate the average stock price

reaction for each quintile in each quarter. The chart provides information about the dynamics of the

overall distribution of earnings reactions over time. The trend in the extreme reactions is well

pronounced. For example the average return of the top (bottom) twenty percent of earnings




                                                  8
reactions was 4.4 (-4.4) percent in 1978 and it has increased (decreased) steadily over the sample

period reaching 9.5 (-9.1) percent at the end of 2004.

         Figure 3 reports the time series of average stock price reactions for five size quintiles. On

average, small stocks are associated with stronger earnings reactions than large stocks – the

average earnings release returns for large stocks are 3.2 percent while for small stocks they are 6.1

percent. Interestingly, the discrepancy across size disappears in crisis periods (years 1987 and

2000) in which the earnings responses are equally strong across all stocks. The up-trend in earnings

responses is well pronounced across all five quintiles. For example, the average absolute returns of

the large-stock quintile increase from 1.7 percent in 1978 to 3.5 percent in 2004, while the returns

of the small-stock quintile increase from 4.6 percent in 1978 to 6.4 percent in 2004.

         We also observe that the average stock price reactions at earnings announcement dates

have increased across the two major exchanges NYSE and NASDAQ (Figure 4). While the trend

for NASDAQ-traded stocks, it is also well-pronounced for NYSE-traded stocks.

         In Table II we examine the statistical significance of the time trend in earnings reactions by

estimating the following linear time trend model:

                  ERt    bT   t                                                                       (1)

         We estimate the model in (1) for both equal-weighted and value-weighted average absolute

price reactions (ERt). In addition, we examine the time trends of price reactions for various

portfolios across negative and positive price reactions; extreme positive and negative price

reactions; the smallest and largest market capitalization quintiles; and NYSE and NASDAQ

stocks.5 All specifications detect a significant positive time trend in earnings reactions over time.




5
  We have also estimated an alternative specifications of the model in (1), including the lagged value of price
reactions to earnings announcements from the previous quarter and dummy variables for the two quarters
with the largest price reactions. All results are qualitatively similar.




                                                      9
We have also conducted a unit root test for the same time series and we reject the null-hypothesis

for the existence of a unit root in the data.

        Table III presents average earnings announcement returns for three subperiods: 1978-1986,

1987-1995, and 1996-2004 and tests the difference of the price reactions between the early and late

subperiods. Consistent with the results from the charts and the time trend model, the upward trend

in earnings-announcement returns is also well pronounced across subperiods. The last two rows of

the table indicate that the differences across subperiods are statistically significant. Here, the trend

is also symmetric and equally strong for both negative and positive reactions. Price reactions to

earnings news are stronger for small stocks than for large stocks over the full sample period. While

both small and large stocks experience significant increase in their price reactions around earnings

announcements, the increase for large stocks is greater.



II. Basic Hypotheses

        In this section we outline a parsimonious model about the stock price volatility at

information releases. The objective of this model is to illustrate the importance of both the quality

of the information signal and the uncertainty of underlying fundamentals for the reaction at the

announcement.

        Earnings are a signal about future cash-flows. Consider a setup in which the current stock

price, P , of a stock is equal to the discounted expected future cash-flows (dividends)

                        x       x2           
                  P   1               ...                                                      (2)
                       1  r (1  r )
                                       2
                                              

Assume that all future dividends are independently and normally distributed random variables

x ~  ( x ,  x ) . Under these assumptions, the price of the stock would be given by
              2




                                                  10
                         E ( x)
                    P                                                                                (3)
                           r

Now consider an information signal (earnings announcement) about the distribution of future

dividends in the form

                    s x ~
                    ~  ~  ,                                                                        (4)

                              ~                            ~
where the noise of the signal  is normally distributed as  ~  (0,  2 ) . The volatility of the

signal,  2 , reflects the noise level of the signal.

            Before the earnings announcement, the price of the stock is equal to the present value of


                                       x  . After the release of the signal, ~ , the new price of the
                                     x 1 ~
expected future cash-flows P                                                    s
                                     r r

stock is equal to the discounted expected future cash flows conditional on the new information,


P  ~ ~  , or:
   1
      xs
   r

                            1      x           
                                     2
                    P( s )   x  2     s  x                                                     (5)
                            r   x  
                                       2
                                                 

The variance of the stock price change at the information release is given by

                                         x 4
                    VarP( s)                                                                       (6)
                                   r 2 ( x   2 )
                                          2




PROPOSITION 1: The volatility of the stock price at earnings announcements is given by (6) and it

    (i)        Increases with the precision of the signal (decreases with the noise of the signal)

    (ii)       Increases with the volatility of future cash flows

    (iii)      Decreases with the level of discount rates




                                                         11
        The proposition follows directly from (5). It is intuitively clear that the magnitude of stock

price reaction at the earnings announcement would be proportional to the precision of the signal (or

inversely related to the noise of the signal  2 ). More precise signals would be associated with

stronger reactions and less precise signals with smaller reactions. When the signal is extremely

noisy (  2 is very large), the variance at the announcement would approach zero, indicating that in

this case the information content of the announcement is extremely low. The stock price reaction at

the announcement increases with the precision of the signal and takes the highest value when the

volatility of the noise is equal to zero. In this case, the volatility of the price change will be equal to

the volatility of the future cash flow  x .
                                         2



        The second part of the proposition indicates that the volatility at the earnings

announcement is proportional to the volatility of underlying cash-flows. The intuition for this result

is that information about more uncertain fundamentals is more valuable. In the extreme case of

deterministic cash-flows, information would have no value since it doesn’t add anything to what

we already know.

        The third part of the proposition reflects changes in the discount rates. Overall, changes in

discount rates are determined by changes in market risk premium, which in turn is determined by

both the risk level of stock returns and the aggregate risk preference of investors. We do not

elaborate on this variable since Vuolteenaho (2002) shows that changes in future cash flows rather

than discount rates explain the majority of the variation in individual stock returns.

        We thus summarize the above results in the following two hypotheses:

        Hypotheses 1: Stock price reaction at earnings announcements is proportional to the

precision of the information signal about future cash flows.

        Hypotheses 2: Stock price reaction at earnings announcements is proportional to the

volatility of future cash flows.




                                                    12
III. Time Series Trends in Earnings-related Variables

         Guided by the predictions of the model from the previous section, here we explore why the

magnitude of earnings announcement returns has increased over time. Is it because the information

quality in earnings as a signal has increased or because the patterns of corporate cash flows have

changed? We start our analysis by identifying a set of variables that could potentially explain the

increase in stock return volatility around earnings announcements and study the time trends in

these variables.



A. Information precision

         In this subsection, we concentrate on variables measuring the noise in earnings

information. The value of earnings information can be summarized by the level of ‘surprise’ of the

earnings news relative to market expectations. We use the following surprise-variables:

         Standardized Unexpected Earnings (SUE). SUE is a commonly used earnings surprise

measure based on the assumption that earnings follow a seasonal random walk process. To estimate

SUE, we follow Foster, Olsen and Shevlin (1984) and assume that firm earnings follow a seasonal

random walk. Under this assumption SUE is defined as the difference of current earnings and

earnings from the same quarter of the previous year normalized with book value of equity.

         Analyst Forecast Error (AFE). Financial analyst earnings forecasts serve as a proxy for

market expectations about future corporate earnings. AFE is defined as the difference between the

actual quarterly earnings per share (EPS) and the most recent mean consensus analyst forecast for

the quarter. The difference is then scaled by both the book value and the market value of equity per

share at the end of the previous quarter.6 We use the unadjusted forecast data from I/B/E/S to

6
 We report results based on the mean analyst forecast, results using median analyst forecast are not tabulated
but exhibit similar patterns.




                                                     13
measure AFE. As discussed in Dieter, Malloy and Scherbina (2002), using the standard I/B/E/S

dataset (i.e., after adjusted for stock splits) will lead to much smaller or the disappearance of

analyst forecast surprises for stocks that have experienced many stock splits.

        The analyst forecast error has several advantages as an earnings surprise measure relative

to alternative measures based on time series forecast of earnings, such as SUE. For example, AFE

does not rely on a forecasting model and is based on a larger information set. This measure is also

widely used in both the accounting and finance literature. In a recent study, Livnat and Mendenhall

(2006) show that earnings surprises calculated from analyst and time series forecast (i.e., SUE)

differ systematically and AFE provides a less noisy measure of earnings surprise. One

shortcoming, though, is that I/B/E/S starts covering quarterly earnings forecasts in 1984. Also, the

number of firms under coverage, particularly in the early period is small.

        The analyst forecast error measures the overall level of informativeness of the earnings

announcement. Larger errors are associated with greater informational content of the earnings

announcement, since in this case the announcement resolves higher uncertainty.

        Analyst Forecast Uncertainty (AFU). This is a measure of the differences of opinion

among financial analysts about future earnings. We again obtain the standard deviations from the

unadjusted earnings forecasts. We scale the standard deviations of earnings forecasts using market

value of equity per share and book value of equity per share. Unlike AFE, AFU captures the

uncertainty of the earnings forecast itself. According to Hypothesis 1, stock price volatility at

earnings announcements is expected to be higher when the divergence of opinions about

fundamentals is higher.

        Figure 5 plots the time-series of equal- and value-weighted standardized unexpected

earnings (SUE). Here, we do not identify a strong trend in the earnings surprises over time. We

note, however, that these surprises are based on a simple statistical model for forming expectations




                                                 14
about future earnings. In reality, investors might use a much wider set of information to predict

earnings.

        Figure 6 presents the time-series of equal- and value-weighted analyst forecast errors and

standard deviations. Panel A plots the average analyst forecast error, defined as the difference

between the actual quarterly earnings per share and the most recent mean consensus analyst

forecast for that quarter scaled by the stock price at the end of previous quarter. We report the time

trends of analyst forecast error and analyst forecast dispersion scaled by book value of equity in

Table IV.

        We observe that analyst forecast errors have decreased steadily over time – from 1.29 in

1978 to 0.28 in 2004. Such trend could reflect the recent advances in financial market towards

greater information production and better corporate disclosure.

        Panel B of Figure 6 presents the time-series of equal- and value-weighted analyst forecast

uncertainty, defined as the standard deviation of analyst earnings forecasts divided by the stock

price. According to Hypothesis 1, the higher the divergence of investor opinion about

fundamentals, the higher the sensitivity of prices to new information would be. Surprisingly, we

find that the divergence of analyst expectations has decreased over time – from 0.56 percent in

1978 to 0.11 percent in 2004. Not only are analysts now able to predict earnings announcement

outcomes more accurately than thirty years ago, but the level of disagreement among them has also

decreased steadily over time.

        One could argue that the downward trend in AFE and AFU (Figure 6) variables is driven

by the fact that stock prices have increased over the sample period, especially during the late 90s.

As a result, we might be simply rediscovering the trend towards higher valuations. This, however,

is not the case. When recalculating the same ratios normalized with book value of equity instead of

market value of equity, we find that that the downward trend here is also very well pronounced. For




                                                 15
example, analyst forecast errors scaled by book value of equity have also decreased steadily over

time – from 1.47 in 1978 to 0.76 in 2004. Dispersion of analyst forecast shows similar trend (Table

IV).

        Results based on analyst earnings forecasts show clearly that the quality of market

predictions about future earnings has improved considerably over the sample period and this seems

inconsistent with the upward trend in earnings announcement stock return volatility. The increased

ability of the market to predict earnings implies that the usefulness of the earnings as a signal has

deteriorated over time. Consider, for instance, the case of perfect foresight in which analysts are

able to predict the exact outcome of future earnings announcements. In this case investors’

attention would shift entirely from corporate announcements to analyst announcements. Earnings

announcements would become a non-event and there will be no reaction at the announcement at

all. This does not imply that earnings information per se has become less important over time. It

implies that the information has advanced over time and investors learn about it earlier7. As a

consequence, changing quality of earnings announcement information seems an unlikely

explanation of the upward trend in earnings announcement volatility.



B. Firm Fundamentals

        In this subsection, we identify a set of variables related to the uncertainty of firm

fundamentals.

        Return on Equity (ROE). Return on equity is the ratio of current earnings relative to book

value of equity. It is a measure of firm profitability. Companies with high return on equity are more

likely to be more mature firms with low growth rates of future cash flows. As a result, we expect
7
  Francis, Schipper, and Vincent (2002b) directly examine whether investors’ use of analyst forecasts
substitutes for their use of earnings announcements information. They find that market reacts to information
in analyst reports but the informativeness of earnings announcements as measured by stock price reactions to
the announcements is not eroded by competing information in the form of analyst reports.




                                                    16
these companies to be associated with lower return volatility around earnings announcements.

More important, we use ROE to construct a direct measure of earnings uncertainty as we discuss

below.

         Volatility of Return on Equity (VROE). This is the standard deviation of quarterly ROE

calculated from the previous five years of data. We delete estimates based on fewer than 12

observations. We use this variable as the measure of the uncertainty of firm fundamentals.

According to Hypothesis 2, the magnitude of stock returns at earnings announcements is positively

related to the volatility of fundamentals.

         Earnings Yield (EY). Earnings yield is the ratio of current earnings relative to market

value of equity and is the inverse of the price-earnings ratio. Unlike ROE, which measures

corporate profitability, earnings yield serves as a measure of market valuations of corporate

earnings. To certain extent, EY is related to the discount rate specified in Equation (6).

         Panel A of Figure 7 plots the time-series of equal- and value-weighted averages of return

on equity. We observe that ROE decreases over time but only for equal-weighted averages which

indicates that the decrease in profitability was concentrated in smaller stocks. The equal-weighted

average reaches the lowest level at the end of 2000 when it becomes negative. Value-weighted

ROE does not show significant time trend, suggesting that level of overall corporate profitability,

especially for large stocks, remains unchanged over the sample period.

         Panel B of Figure 7 plots the time-series of equal- and value-weighted earnings yields in

the market. Earnings yields have declined significantly over time – from 3.2 in 1978 to 1.1 in 2004.

Since earnings yields are inversely related to price/earnings ratios, this trend also represents a

steady increase in the price-earnings ratios over the last 27 years. The time trend of earnings yields,

combined with the relative stability of ROE, indicates that the increase in the valuation ratios over




                                                  17
the sample period is largely driven by increased market valuations rather than decreased firm

profitability.

         Figure 8 presents the time-series of equal- and value-weighted averages of the standard

deviation of ROE calculated based on the previous five years of data. We observe that the volatility

of corporate earnings increases over time. In 1978, it was 1.86 percent and in 2004 it was 4.7

percent. The value-weighted volatility line lies below the equal-weighted line, indicating that the

fundamentals of large stock are less volatile then the fundamentals of small stocks. Despite the

lower magnitude, the up-ward trend here is even stronger – the value-weighted volatility increased

from 1.15 percent in 1978 to 3.57 percent in 2004.

         Valuation ratios and earnings volatility span two different dimensions of uncertainty of

future cash-flows. Higher valuation ratios, on one hand, indicate that today the market capitalizes

long-term growth opportunities more heavily than it used to three decades ago. Earnings volatility,

on the other hand, indicates that not only long-term fundamentals but also short-term cash-flows

have become more uncertain. These results are consistent with the observed up-ward trend in stock

price reactions around earnings announcements. As summarized in Hypothesis 2 of the previous

section, more uncertain fundamentals would make prices more responsive to information releases.

         Table IV represents a different way of looking at the data. It summarizes the analyst

forecast error, analyst forecast uncertainty, the standard deviation of ROE, and earnings yield for

three subperiods: 1978-1986, 1987-1995, and 1996-2004. Each one of the above four variables is

normalized with both book value of equity and market value of equity. The last two rows test the

statistical significance of the difference in means between the first and the last subperiods. The

subperiod results are consistent with the results from the charts. They confirm that analyst forecast

error, analyst forecast uncertainty, and earnings yields have decreased over time, while earnings




                                                 18
volatility has increased. Note that ratios based on market prices are usually more volatile than

ratios based on book values since market values are more volatile than book values.

        In sum, the preliminary evidence on the increased volatility around earnings

announcements is inconsistent with the information precision stories since the relative importance

of earnings information is deteriorating over time. The upward trend in earnings announcement

stock return volatility is more consistent with the changing fundamentals stories. In the next

section, we directly test the relation between firm fundamentals and the price reactions to earnings

announcements.



IV. Firm Fundamentals and Price Reaction to Earnings News

        In this section we study the importance of firm fundamentals in explaining the time trend

of stock return volatility around earnings announcements.



IV.A. Cross sectional analysis

        We first implement cross-sectional analysis of the relation between price reactions at

earnings announcements and various earnings and firm characteristics. Given the high correlation

between earnings yield and ROE, we include only ROE in the analysis. In addition to the earnings

variables introduced in the previous section, we include the following control variables:

        Size. We measure stock size with the market value of firm equity. Firm size, in logarithm,

is sampled at the end of the previous year. Firm size is related to the level of information

asymmetry and is positively correlated with both analyst coverage and institutional investor

holdings. As we show earlier, firm size is related to both earnings surprises and return volatility

around earnings announcements.




                                                 19
        Book-to-market Ratio (BE/ME). Stock’s book-to-market ratio is defined as the ratio of

book value of equity over market value of equity at the end of the previous year. It is a relative

valuation ratio for firm’s equity and it reflects the present value of growth opportunities. We use

book-to-market as a valuation metric in the cross-sectional regressions since it is less noisy relative

to alternative metrics, such as price-earnings ratios. The sensitivity of stock prices to new

information is stronger when the growth rate of future cash-flows is higher. Since long-term growth

rates are difficult to measure directly, book to market ratios serve as a proxy for growth

opportunities – low book-to-market ratios (high valuations) indicate high growth rates; high book-

to-market ratios (low valuations) indicate low growth rates.

        Leverage. We measure leverage using the ratio of total debt to total assets. Firm leverage

is related to both the volatility of earnings and overall firm risk.

        Age. We measure the age of firms in our sample using the number of years the firm has

been in the CRSP database. Firm age is related to maturity and earnings volatility of the firm. Firm

age could also be related to the level of information asymmetry of the firm. We use logarithm of

age in the regression.

        Institutional Holdings. The level of institutional ownership is calculated as the percentage

of shares owned by institutions relative to total number of shares outstanding at the end of each

quarter. There are two general ways through which institutional investors could have an impact on

the way prices react to earnings information. On the one hand, if institutional investors are better

informed, then they should be less surprised by the announcement. As a result, the presence of

institutional investors in a stock would be associated with smaller stock price reactions on earnings

announcement days8. On the other hand, if institutions are more likely to respond to information

8
  Consistent with the information story, a variety of empirical studies provide evidence that institutions
posses better information and information-processing skills than individual investors (see Grinblatt and
Titman (1989, 1993), Daniel, Grinblatt, Titman, and Wermers (1997), Wermers (1999, 2000), and Bennett,
Sias, and Starks (2003)).




                                                    20
than individual investors, stocks with higher institutional ownership could react more strongly to

earnings information.

        In Table V we estimate the cross-sectional regressions for each quarter. The table reports

time series averages of the coefficient estimates and t-statistics for the three subperiods: 1978-

1986, 1987-1995, and 1996-2004. In Model 1 we use SUE as a measure of earnings surprise. In

Model 2, we substitute this variable with analyst-related variables and add institutional ownership.

We note that the results here are not simply a multivariate extension of the univariate results form

the previous section. In the previous section, we looked at the time-series trends in the explanatory

variables – here we study the cross-sectional sensitivity of absolute earnings returns to these

variables, particularly the earnings information variables and measures of uncertainty of firm

fundamentals. This cross-sectional analysis provides additional insight on the trend in earnings

announcement returns, since a variable might contribute to the trend in two separate ways –

through changes in its levels or through changes in its relative importance over time.

        The cross-sectional results confirm that stocks with more volatile earnings (higher

volatility of return on equity) have stronger reactions at earnings announcements. The sensitivity of

earnings announcement stock returns to earnings volatility has also increased over time in both

models. The increasing significance of VROE in explaining the cross-sectional variation of

earnings-announcement volatility and the fact that VROE has indeed increased strongly over time

indicate that the uncertainty of firm fundamentals plays an important role in explaining the up-ward

trend in stock price reactions around earnings announcements.

        Price reactions to earnings announcements are also positively related to earnings surprises -

both SUE and AFE are significant in the regressions. Interestingly, the importance of earnings

surprises (AFE) in the cross-sectional regressions increases over time, wile at the same time, the

level of earnings surprises decreases. In other words, missing an analyst expectation would result in




                                                 21
a larger stock price reaction today than thirty years ago. At the same time, however, the chance of

missing an expectation today is much smaller than it used to be thirty years ago. The dispersion of

financial analyst forecasts (AFU) does not significantly relate to the magnitude of the price

reactions at earnings announcements.

        The other control variables are also significantly related to price reactions at earnings

announcements. Size is negatively related to earnings announcement returns. This is consistent

with Figure 4, indicating that small stocks react stronger to earnings announcements. Firms with

higher book-to-market ratios have weaker earnings announcement reactions. This is consistent with

the interpretation that high book-to-market firms have lower valuation ratios and as a result lower

future growth opportunities. Both leverages and firm age are negatively related to the price

volatility at earnings announcements. The result for firm age is not surprising, since more mature

firms are generally perceived as being less risky. The causality for leverage could go both ways.

On one hand, leverage could increase stock price volatility since it increase the overall risk level of

the firm. On the other hand, the leverage ratio could be endogenously determined by earnings

volatility and firm risks. As a result, less risky firms would have higher leverage ratios.

        Less profitable firms experience stronger price reactions at earnings announcements. The

economic and statistical significance of ROE in the cross-sectional regression also increases over

the sample period. The profitability of the average firm, however, has decreases over time. As a

result, the net effect of ROE on the return volatility around earnings announcements is unclear.

Lastly, the institutional ownership variable is positively related to the level of price reactions.



IV. B. The time series evidence




                                                   22
         In this subsection we examine directly the link between fundamentals uncertainty and the

upward trend in earnings announcement volatility by including earnings volatility as an

independent variable in the linear time trend model of equation (1):

         ERt    b1T  b2VROE t   t                                                            (7)

         We estimate the model in (7) for both equal-weighted and value-weighted average price

reactions at earnings announcements along with equal-weighted and value-weighted earnings

volatility.

         Table VI shows that average earnings volatility in the market explains the time trend of

average price reactions at earnings announcements. In both the equal-weighted and value-weighted

regressions, the time trend variable becomes insignificant, while the earnings volatility variables

remain highly significant. The above results are robust to various specifications that include lagged

values of price reactions and earning volatility. When substituting the volatility of return on equity

with other variables, such as profitability (ROE), earnings yields, and various measures of earnings

surprises and forecast uncertainty, we show that these variables are unable to explain the time trend

of return volatility around earnings announcements.



V. Changes of Price Reactions and Post-earnings Announcement Drift

         The magnitude of the stock price reactions at earnings announcements has increased over

time. We argue that this up-ward trend in return volatility around earnings announcements is due to

the fact that the fundamentals of the typical firm in the market have become more uncertain over

time. Many corporate executives and regulators, however, take a different stand on the issue. They

argue that stock price reactions at earnings announcements are excessive (see the Introduction) and

can not be justified by fundamentals.




                                                 23
        In this subsection we shed further light on this question by looking at the stock price

behavior following the announcement. Many academic studies have documented robust evidence

of post-earnings announcement drift and one common interpretation of this phenomenon is

underreaction to earnings information (see Bernard and Thomas (1989)). If investors now overreact

to earnings information, we would expect that the post-earnings announcement drift would weaken

(or even disappear) over time.

        In Table VII we sort stocks into quintiles according to their earnings surprises and earnings

announcement returns and calculate abnormal returns for the most positive (first panel) and most

negative (last panel) quintiles over 5-, 10-, 20-, and 60-day periods after earnings announcements.

We calculate the abnormal return based on the difference between the stock’s cumulative return

over the period and the cumulative return of its corresponding size decile portfolio for the same

period. We calculate average abnormal stock returns for the three subperiods: 1978-1986, 1987-

1995, and 1996-2004.

        Panel A reports results for earnings surprise portfolios sorted on AFE. Consistent with the

earlier results, the price reactions at the earnings announcement for both the “Most Negative” and

“Most Positive” earnings surprise portfolios are increasing over time. The magnitude of the post-

earnings announcement drift for these portfolios, however, remains substantially unchanged over

the sample period.

        Panel B reports results for earnings surprise portfolios based on the actual price reactions at

the announcement. Compared with the stock return results in Panel A, there are some noticeable

differences. Stock price drifts following the most negative stock price reactions here are markedly

stronger for the latest period. Abnormal 60 day-returns for the latest period are -2.48%, while for

the first period they are -0.97%. More interestingly, there is a consistent price continuation




                                                  24
following negative price reactions in the latest period over short holding periods, while stock prices

experience even short term reversals following negative price reactions in the earlier period.

        In sum, even though price reactions around earnings announcements have increased over

time, post-earnings announcement price drifts remain significant. In fact, the magnitude of the drift

has even increased following extreme negative earnings news. This suggests that the market does

not overreact to earnings information and lends further support to the fundamentals-explanation of

the increasing earnings-related volatility.



VI. Conclusion

        Stock price reactions at earnings announcements have increased substantially over the last

three decades. At the same time the relative importance of earnings has actually decreased over

time. The last few decades have seen tremendous growth of the security analysis industry and

numerous financial innovations, all of which facilitate the extraction of information from firms

prior to earnings announcements. As a result, one would expect stock price volatility at earnings

announcement to decrease over time.

        To reconcile these two findings we propose an explanation based on the fact the

uncertainty of firm fundamentals has increased over time. In a world of more uncertain

fundamentals, prices will react more at information releases since information here would resolve

more uncertainty. We confirm this hypothesis by showing that measures of the average cash-flow

uncertainty in the market can explain the up-ward trend in stock price reactions at earnings

announcements.

         Our analysis suggests that the claim often made by corporate executives that investors

react too aggressively to earning news is unfounded. Our findings also imply that, given the change

of firm fundamentals, increasing the frequency of information disclosure may not be helpful in




                                                 25
reducing the magnitude of stock price reactions to information. If the increased volatility in

markets reflects changes in fundamental variables, then this volatility, while undesirable, may be

unavoidable.




                                               26
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                                                 28
                                                 Table I
                                             Summary Statistics

Presented are the total number of stocks, the percentage of stocks with analyst coverage, the average number
of analysts per stock, the percentage of stocks with positive institutional ownership, and the average level of
institutional ownership relative to total number of shares outstanding. The sample includes domestic common
stocks traded on NYSE, AMEX, and NASDAQ from 1978 to 2004. We exclude REITs, closed-end funds,
ADRs, stocks priced below $5, and stocks in the lowest market capitalization decile based on NYSE break
points as of the end of the previous year.




                                             Percentage of
                                              Stocks with      Average     Average Level of
                             Number of          Analyst       Number of      Institutional
                   Year       Stocks           Coverage        Analysts       Ownership
                   1978         1556              ---            ---               ---
                   1980         1544              ---            ---              0.21
                   1983         1900              ---            ---              0.28
                   1986         2003             0.60            4.4              0.31
                   1989         2019             0.83            5.6              0.36
                   1992         2371             0.92            5.5              0.41
                   1995         3069             0.91            5.4              0.44
                   1998         3112             0.94            6.3              0.48
                   2001         2768             0.88            7.3              0.53
                   2004         2314             0.97            8.6              0.60




                                                        29
                                               Table II
                         Linear Trend in Earnings Announcement Stock Returns

We calculate earnings-announcement stock returns as the cumulative return of the stock over a three day
window centered at the earnings announcement date net of the cumulative return of a benchmark portfolio of
stocks with similar market capitalization. The benchmark portfolios are based on NYSE market capitalization
deciles as of the end of the previous year. Afterwards, we calculate equal- and value-weighted averages of
the absolute value of the earnings announcement stock returns for the whole market and for the portfolios of
positive and negative price reactions; extreme positive and extreme negative price reactions; the quintiles of
the smallest and largest stocks; and NYSE and Nasdaq stocks. The table estimates time series regressions of
average portfolio earnings reactions on a linear time-trend variable.


                                     Intercept        T-stat.               Time            T-stat.
          Equally-weighted             2.55           16.58                 0.031           12.65
           Value-weighted              1.93           12.37                 0.023            9.22

         Negative Reactions
                                       2.43           15.35                0.0324           12.87
          Positive reactions           2.68           15.76                0.0297           10.95

            Most negative              4.58           15.39                0.0629           13.29
            Most positive              4.94           15.44                0.0618           12.12

          Smallest quintile            4.47           26.76                0.0309            11.6
          Largest quintile             1.77            9.07                0.0264            8.51

            NYSE stocks                2.57           19.54                0.0187            8.93
            Nasdaq stocks              2.35           13.19                0.0459           16.22




                                                      30
                                              Table III
                           Average Stock Returns at Earnings Announcements

We calculate earnings-announcement stock returns as the cumulative return of the stock over a three day
window centered at the earnings announcement date net of the cumulative return of a benchmark portfolio of
stocks with similar market capitalization. The benchmark portfolios are based on NYSE market capitalization
deciles as of the end of the previous year. Then, for each quarter, we construct equal- and value-weighted
averages of absolute earnings announcement returns (first two columns), average positive and negative
announcement returns (next two columns), and average announcement returns for quintile portfolios of small
and large stocks (last two columns). The table reports means and medians of the above time series for three
subperiods: 1978-1986, 1987-1995, and 1996-2004. The last two rows test the statistical significance of the
difference in means between the first and the last subperiods.



                          EW             VW           Negative   Positive     Small Stocks Large Stocks
      Period 1978-1986
        Mean           0.032            0.025          -0.060      0.062         0.039          0.024
        Median         0.022            0.018          -0.049      0.051         0.027          0.018
      Period 1987-1995
        Mean           0.040            0.029          -0.076      0.078         0.049          0.028
        Median         0.026            0.020          -0.059      0.064         0.034          0.019
      Period 1996-2004
        Mean           0.056            0.044          -0.106      0.111         0.059          0.044
        Median         0.035            0.029          -0.082      0.089         0.037          0.029
      Difference b/w first and last period
        Mean             0.024           0.019         -0.047      0.049         0.020          0.020
        T-stat.          84.28           49.95         -73.20      82.41         33.96          41.72




                                                      31
                                               Table IV
                              Average Earnings Variables across Sub-periods

For each quarter, we construct averages of the following four variables: analyst forecast error, defined as the
difference between the actual quarterly earnings per share (EPS) and the most recent mean consensus analyst
forecast for that quarter; analyst forecast uncertainty, defined as the standard deviations of unadjusted
earnings forecasts; earnings volatility, defined as the standard deviation of ROE calculated from the previous
five years of data; and earnings yield, defined as the scaled current earnings. We normalize each one of the
above four variables with both book value of equity and market value of equity. The table reports means and
medians of the above time series for three subperiods: 1978-1986, 1987-1995, and 1996-2004. The last two
rows test the statistical significance of the difference in means between the first and the last subperiods.



                Analyst Forecast Error               AFU             Earnings Volatility       Earnings Yield
                   BE           ME             BE            ME        BE        ME            BE        ME
 Period 1978-1986
   Mean         1.397           1.003        0.538         0.380      2.353       2.243       3.142      2.289
   Median       0.500           0.300        0.300         0.200      1.435       1.339       3.550      2.318
 Period 1987-1995
   Mean         1.016           0.576        0.500         0.257      3.986       2.394       2.306      1.064
   Median       0.400           0.200        0.300         0.100      2.227       1.236       3.170      1.487
 Period 1996-2004
   Mean         0.843           0.313        0.423         0.140      4.813       2.229       1.402      0.458
   Median       0.300           0.100        0.200         0.100      2.594       1.143       2.870      1.134
 Difference b/w first and last period
   Mean          -0.550        -0.690        -0.120      -0.240      2.500       -0.010       -1.740     -1.830
   T-stat.       -18.06        -27.30         -9.27      -23.20      113.19       -0.88       -49.45     -88.51




                                                        32
                                               Table V
                    Cross-sectional Determinant of Earnings Announcement Returns

First, for each quarter, we regress the absolute value of the three-day earnings announcement stock return on
the following set of independent variables: the logarithm of the market capitalization of the stock at the end
of the previous year, the book-to-market equity ratio at the end of the previous year (BE / ME); leverage,
defined as ratio of total debt to assets; Age, defined as the logarithm of the number of years the stock has
been in the CRSP database; the ratio of current earnings and book value of equity (ROE); the standard
deviation of ROE calculated based on the previous five years of data (VROE); standardized unexpected
earnings (SUE), defined as the difference between current earnings and earnings form the same quarter of the
previous year normalized with book value of equity; analyst forecast error (AFE), defined as the difference
between the actual quarterly earnings per share and the most recent mean consensus analyst forecast for that
quarter scaled by the stock price at the end of previous quarter; analyst forecast uncertainty (AFU), defined
as the standard deviation of analyst earnings forecast divided by the stock price; and the fraction of shares
held by institutions at the end of the previous quarter. Afterwards, we estimate time-series averages of the
estimated coefficients for three subperiods: 1978-1986, 1987-1995, and 1996-2004.




                                                     33
                           (1)                              (2)
                78-86     87-95          96-04   78-86     87-95     96-04
Intercept        0.0529    0.0751     0.0879      0.0706    0.0760    0.0880
                 44.58     39.66      36.63         8.58     62.16     45.14
Log Size        -0.0025   -0.0025    -0.0012     -0.0033   -0.0032   -0.0027
                 -11.73    -17.40      -3.55       -2.35    -27.91    -13.92
BE / ME         -0.0049   -0.0068    -0.0106     -0.0057   -0.0082   -0.0116
                 -10.29     -8.29      -7.69       -3.65    -12.12    -11.60
Leverage         0.0004   -0.0085    -0.0165     -0.0028   -0.0101   -0.0225
                   0.32     -6.52      -9.56       -1.53     -8.77    -15.84
Age             -0.0020   -0.0069    -0.0093     -0.0053   -0.0069   -0.0089
                  -4.45    -19.60     -16.81       -8.57    -24.90    -23.18
ROE             -0.0178   -0.0111    -0.0285     -0.1028   -0.0246   -0.0302
                  -3.28     -2.73      -5.43       -2.11     -6.45     -5.36
VROE             0.0796    0.0520     0.1033      0.0220    0.0595    0.1077
                   8.72      9.94     11.91         0.49     16.30     14.44
SUE              0.1132    0.0924     0.1304
                 11.10       9.24       4.80
AFE                                              0.1702    0.2999    0.8752
                                                  3.35       9.40      8.34
AFU                                              0.0440    0.1165    0.0249
                                                  0.31       1.83      0.15
Inst. Holding                                    0.0051    0.0125    0.0212
                                                  1.57      14.42     17.18
Adj. R-square   0.059     0.072          0.077   0.078     0.095     0.092




                                    34
                                              Table VI
                       Linear Trends in Earnings Announcement Stock Returns

We calculate earnings-announcement stock returns as the cumulative return of the stock over a three day
window centered at the earnings announcement date net of the cumulative return of a benchmark portfolio of
stocks with similar market capitalization. The benchmark portfolios are based on NYSE market capitalization
deciles as of the end of the previous year. Afterwards, we calculate equal- and value-weighted averages of
the absolute value of the earnings announcement stock returns for each quarter. The table estimates time
series regressions of absolute earnings returns on a linear time-trend variable (first two columns) and on a
linear time-trend variable and lagged average earnings announcement returns (last two columns).


                                 Equally-weighted                    Value-weighted
                             Coefficient     T-stat.           Coefficient      T-stat.
                  Alpha         0.0137          3.08              0.0082            1.88
                  Time          0.0001          1.15             -0.0001           -0.47
                  VROE          0.6433          2.83              0.9949            2.72
                 R-square       0.6296                           0.4815




                                                    35
                                              Table VII
                         Post Earnings Announcements Drifts across Sub-periods

For each quarter, we sort earnings surprises based on analyst forecast error and price reaction to earnings
announcements into five equal sized portfolios. Analyst forecast error is defined as the difference between
the actual quarterly earnings per share (EPS) and the most recent mean consensus analyst forecast for that
quarter normalized by book value of equity; price reaction to earnings-announcement stock returns is defined
as the cumulative return over a three day window centered at the earnings announcement date net of the
cumulative stock return of a benchmark portfolio of stocks with similar market capitalization. We calculate
size adjusted cumulative stock returns for the most negative and most positive earnings surprise portfolios
over 5, 10, 20 and 60 trading days after the three-day announcement period for three subperiods: 1978-1986,
1987-1995, and 1996-2004. Panel A reports results based on earnings surprise ranking and Panel B reports
results based on price reactions ranking.


 Panel A: Based on earnings surprise ranking
                      period         reaction          5 day      10 day         20 day         60 day

 Most Negative         1978-1986            -1.16**     0.21       0.08           0.02         -1.32**
                       1987-1995            -1.90**     0.00       0.01         -0.22**        -2.27**
                       1996-2004            -2.61**   -0.31**    -0.32**        -0.30**        -1.86**

 Most Positive         1978-1986            1.59**    0.20**      0.72**         1.09**         1.91**
                       1987-1995            2.34**     -0.03      0.45**         1.13**         2.55**
                       1996-2004            2.85**    0.11**      0.40**         0.97**         1.28**

 Panel B: Based on price reaction ranking
                       period         reaction          5 day     10 day         20 day         60 day
 Most Negative      1978-1986         -5.99**          0.24**     0.42**         0.31**        -0.97**
                    1987-1995         -7.57**           0.11       0.18           0.06         -1.41**
                    1996-2004        -10.64**         -0.43**    -0.58**        -0.57**        -2.48**

 Most Positive         1978-1986             6.20**     0.12      0.31**         0.50**         0.75**
                       1987-1995             7.85**    -0.12       0.09          0.61**         1.33**
                       1996-2004            11.08**    -0.03      0.23**         0.71**         0.73**

** denotes significance at 5 percent level.




                                                      36
                                                                   EW                                                                      VW                                                                                                                    Negative                          Positive
                                                                                                                                                                                                                            10.0%
 9.0%

                                                                                                                                                                                                                             9.0%
 8.0%

                                                                                                                                                                                                                             8.0%
 7.0%

                                                                                                                                                                                                                             7.0%
 6.0%
                                                                                                                                                                                                                             6.0%

 5.0%
                                                                                                                                                                                                                             5.0%

 4.0%
                                                                                                                                                                                                                             4.0%

 3.0%                                                                                                                                                                                                                        3.0%


 2.0%                                                                                                                                                                                                                        2.0%


                                                                                                                                                                                                                             1.0%
 1.0%

                                                                                                                                                                                                                             0.0%
 0.0%




                                                                                                                                                                                                                                  78

                                                                                                                                                                                                                                  79

                                                                                                                                                                                                                                  80

                                                                                                                                                                                                                                  81

                                                                                                                                                                                                                                  83

                                                                                                                                                                                                                                  84

                                                                                                                                                                                                                                  85

                                                                                                                                                                                                                                  86

                                                                                                                                                                                                                                  88

                                                                                                                                                                                                                                  89

                                                                                                                                                                                                                                  90

                                                                                                                                                                                                                                  91

                                                                                                                                                                                                                                  93

                                                                                                                                                                                                                                  94

                                                                                                                                                                                                                                  95

                                                                                                                                                                                                                                  96

                                                                                                                                                                                                                                  98

                                                                                                                                                                                                                                  99

                                                                                                                                                                                                                                  00

                                                                                                                                                                                                                                  01

                                                                                                                                                                                                                                  03

                                                                                                                                                                                                                                  04
        1978

                1979
                       1980

                              1981
                                     1982

                                              1983
                                                     1984

                                                            1985

                                                                    1986

                                                                           1987

                                                                                  1988
                                                                                         1989

                                                                                                1990
                                                                                                        1991

                                                                                                               1992
                                                                                                                      1993

                                                                                                                             1994
                                                                                                                                    1995

                                                                                                                                            1996
                                                                                                                                                   1997

                                                                                                                                                          1998
                                                                                                                                                                 1999

                                                                                                                                                                        2000
                                                                                                                                                                                 2001

                                                                                                                                                                                        2002
                                                                                                                                                                                                2003

                                                                                                                                                                                                       2004




                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               19

                                                                                                                                                                                                                               20

                                                                                                                                                                                                                               20

                                                                                                                                                                                                                               20

                                                                                                                                                                                                                               20
                                Panel A. Absolute value                                                                                                                                                                                          Panel B. Positive vs. Negative


Figure 1. Average Earnings Announcement Stock Returns. Earnings-announcement stock returns are
calculated as the cumulative return of the stock over a three day window centered at the earnings
announcement date net of the cumulative return of a benchmark portfolio of stocks with similar market
capitalization. Panel A plots the time-series of equal- and value-weighted averages of absolute earnings
announcement returns. Panel B plots the time series of the average positive and negative announcement
returns.




                                                     Q1 (Negative)                                                                                 Q2                                                  Q3                             Q4                              Q5 (Positive)

        20.0%


        15.0%


        10.0%


               5.0%


               0.0%
                              1978
                                            1979
                                                     1980
                                                                   1981
                                                                              1982
                                                                                         1983
                                                                                                       1984
                                                                                                                 1985
                                                                                                                             1986
                                                                                                                                           1987
                                                                                                                                                     1988
                                                                                                                                                                 1989
                                                                                                                                                                               1990
                                                                                                                                                                                         1991
                                                                                                                                                                                                       1992
                                                                                                                                                                                                              1993
                                                                                                                                                                                                                     1994
                                                                                                                                                                                                                            1995
                                                                                                                                                                                                                                   1996
                                                                                                                                                                                                                                          1997
                                                                                                                                                                                                                                                 1998
                                                                                                                                                                                                                                                        1999

                                                                                                                                                                                                                                                               2000
                                                                                                                                                                                                                                                                       2001
                                                                                                                                                                                                                                                                              2002
                                                                                                                                                                                                                                                                                     2003
                                                                                                                                                                                                                                                                                            2004




          -5.0%


        -10.0%


        -15.0%


        -20.0%




Figure 2. Average Earnings Announcement Stock Returns Across Return Quintiles. Earnings-
announcement stock returns are calculated as the cumulative return of the stock over a three day window
centered at the earnings announcement date net of the cumulative return of a benchmark portfolio of stocks
with similar market capitalization. The figure plots the time series of average earnings announcement returns
across quintile portfolios stratified on the magnitude of the return.




                                                                                                                                                                                                                            37
 12.0%                                              Q1 (Small)                                Q2                          Q3                   Q4                            Q5 (Large)


 10.0%


  8.0%


  6.0%
                                                                                                       1

  4.0%


  2.0%


  0.0%
         1978
                   1979
                             1980
                                      1981
                                             1983
                                                    1984
                                                           1985
                                                                   1986
                                                                             1988
                                                                                       1989
                                                                                                1990
                                                                                                           1991
                                                                                                                   1993
                                                                                                                           1994
                                                                                                                                   1995
                                                                                                                                            1996
                                                                                                                                                      1998
                                                                                                                                                               1999
                                                                                                                                                                       2000
                                                                                                                                                                               2001
                                                                                                                                                                                      2003
                                                                                                                                                                                             2004
Figure 3. Average Earnings Announcement Stock Returns Across Size Quintiles. Earnings-
announcement stock returns are calculated as the cumulative return of the stock over a three day window
centered at the earnings announcement date net of the cumulative return of a benchmark portfolio of stocks
with similar market capitalization. The figure plots the time series of average earnings announcement returns
across size-quintile portfolios.

                                                                             NYSE                                         NASDAQ
   12.0%


   10.0%


    8.0%


    6.0%


    4.0%


    2.0%


    0.0%
            1978

                          1979

                                    1981

                                             1982

                                                    1984

                                                            1985

                                                                      1987

                                                                                    1988

                                                                                              1990

                                                                                                       1991

                                                                                                                   1993

                                                                                                                            1994

                                                                                                                                     1996

                                                                                                                                               1997

                                                                                                                                                             1999

                                                                                                                                                                      2000

                                                                                                                                                                               2002

                                                                                                                                                                                      2003




Figure 4. Average Earnings Announcement Stock Returns: NYSE vs. NASDAQ. Earnings-
announcement stock returns are calculated as the cumulative return of the stock over a three day window
centered at the earnings announcement date net of the cumulative return of a benchmark portfolio of stocks
with similar market capitalization. The figure plots the time-series of average earnings announcement returns
across NYSE and NASDAQ.




                                                                                                                  38
                                                                                                                                              SUE ew                                    SUE vw

   2.50


   2.00


   1.50


   1.00


   0.50


   0.00
                   1978

                                      1979

                                                      1981

                                                                     1982

                                                                                    1984

                                                                                                        1985

                                                                                                                        1987

                                                                                                                                       1988

                                                                                                                                                      1990

                                                                                                                                                                   1991

                                                                                                                                                                          1993

                                                                                                                                                                                        1994

                                                                                                                                                                                                      1996

                                                                                                                                                                                                                     1997

                                                                                                                                                                                                                                   1999

                                                                                                                                                                                                                                                   2000

                                                                                                                                                                                                                                                                 2002

                                                                                                                                                                                                                                                                                   2003
Figure 5. Standardized Unexpected Earnings. Presented are the time-series of equal- and value-weighted
standardized unexpected earnings (SUE), defined as the difference between current earnings and earnings
form the same quarter of the previous year normalized with book value of equity.




                                                                        AFE ew                                   AFE vw                                                                                                                     AFU ew                                  AFU vw


   1.40                                                                                                                                                                   0.60


   1.20
                                                                                                                                                                          0.50

   1.00
                                                                                                                                                                          0.40
   0.80

                                                                                                                                                                          0.30
   0.60


   0.40                                                                                                                                                                   0.20


   0.20
                                                                                                                                                                          0.10

   0.00
          1984
                 1985
                        1986
                               1987
                                        1988
                                               1989
                                                       1990
                                                              1991
                                                                     1992
                                                                            1993
                                                                                   1994
                                                                                          1995
                                                                                                 1996
                                                                                                          1997
                                                                                                                 1998
                                                                                                                         1999
                                                                                                                                2000
                                                                                                                                       2001
                                                                                                                                              2002
                                                                                                                                                     2003
                                                                                                                                                            2004




                                                                                                                                                                          0.00
                                                                                                                                                                                 1984
                                                                                                                                                                                        1985
                                                                                                                                                                                               1986
                                                                                                                                                                                                      1987
                                                                                                                                                                                                             1988
                                                                                                                                                                                                                    1989
                                                                                                                                                                                                                           1990
                                                                                                                                                                                                                                  1991
                                                                                                                                                                                                                                         1992
                                                                                                                                                                                                                                                1993
                                                                                                                                                                                                                                                       1994
                                                                                                                                                                                                                                                              1995
                                                                                                                                                                                                                                                                     1996
                                                                                                                                                                                                                                                                            1997
                                                                                                                                                                                                                                                                                    1998
                                                                                                                                                                                                                                                                                           1999
                                                                                                                                                                                                                                                                                                  2000
                                                                                                                                                                                                                                                                                                         2001
                                                                                                                                                                                                                                                                                                                2002
                                                                                                                                                                                                                                                                                                                       2003
                                                                                                                                                                                                                                                                                                                              2004




                        Panel A. Analyst Forecast Error                                                                                                                                               Panel B. Analyst Forecast Uncertainty

Figure 6. Analyst Forecasts. Panel A presents the time-series of equal- and value-weighted analyst forecast
errors, defined as the difference between the actual quarterly earnings per share and the most recent mean
consensus analyst forecast for that quarter scaled by the stock price at the end of previous quarter. Panel B
presents the time-series of equal- and value-weighted analyst forecast uncertainty, defined as the standard
deviation of analyst earnings forecasts divided by the stock price.




                                                                                                                                                                          39
                                                                                                                                                                                                                            EY ew                            EY vw
                                                                  ROE ew                               ROE vw

                                                                                                                                                          0.05
   7.00%


   6.00%                                                                                                                                                  0.04

   5.00%
                                                                                                                                                          0.03
   4.00%
                                                                                                                                                          0.02
   3.00%


   2.00%                                                                                                                                                  0.01

   1.00%
                                                                                                                                                              0




                                                                                                                                                                  1978

                                                                                                                                                                         1979

                                                                                                                                                                                 1981

                                                                                                                                                                                        1982

                                                                                                                                                                                               1984

                                                                                                                                                                                                      1985

                                                                                                                                                                                                              1987

                                                                                                                                                                                                                     1988

                                                                                                                                                                                                                             1990

                                                                                                                                                                                                                                      1991

                                                                                                                                                                                                                                             1993

                                                                                                                                                                                                                                                    1994

                                                                                                                                                                                                                                                           1996

                                                                                                                                                                                                                                                                  1997

                                                                                                                                                                                                                                                                          1999

                                                                                                                                                                                                                                                                                 2000

                                                                                                                                                                                                                                                                                          2002

                                                                                                                                                                                                                                                                                                 2003
   0.00%
            1978

                   1979

                           1981

                                  1982

                                          1984

                                                 1985

                                                          1987

                                                                 1988

                                                                        1990

                                                                               1991

                                                                                      1993

                                                                                             1994

                                                                                                    1996

                                                                                                           1997

                                                                                                                  1999

                                                                                                                          2000

                                                                                                                                 2002

                                                                                                                                         2003
                                                                                                                                                         -0.01
   -1.00%


   -2.00%                                                                                                                                                -0.02




                   Panel A. ROE                                                                                                                                                     Panel B. Earnings Yield

Figure 7. Time Trend of ROE and Earnings Yield.
Panel A plots the time-series of equal- and value-weighted averages of the ratio of current earnings over book
value of equity. Panel B Presented are the time-series of equal- and value-weighted yearnings yield averages
in the market, defined as the ratio of current earnings and market value of equity.




                                                                                                                                            VROE ew                                      VROE vw

   7.00%

   6.00%

   5.00%

   4.00%

   3.00%

   2.00%

   1.00%

   0.00%
                          1978
                                         1979
                                                        1980
                                                                   1981
                                                                                1983
                                                                                             1984
                                                                                                           1985
                                                                                                                         1986
                                                                                                                                        1988
                                                                                                                                                1989
                                                                                                                                                       1990
                                                                                                                                                                  1991
                                                                                                                                                                                1993
                                                                                                                                                                                           1994
                                                                                                                                                                                                       1995
                                                                                                                                                                                                                     1996
                                                                                                                                                                                                                                    1998
                                                                                                                                                                                                                                               1999
                                                                                                                                                                                                                                                           2000
                                                                                                                                                                                                                                                                         2001
                                                                                                                                                                                                                                                                                        2003
                                                                                                                                                                                                                                                                                                  2004




Figure 8. Volatility of ROE. plots the time-series of equal- and value-weighted averages of the standard
deviation of ROE calculated based on the previous five years of data.




                                                                                                                                                        40

				
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