Getting Bad News Out Early: Does It Really Help Stock Prices?

Getting Bad News Out Early: Does it Really Help
Stock Prices?
Chris Downing and Steve Sharpe
October 2, 2003
Abstract
In this paper, we examine the stock price benet of meeting or beating earnings
expectations. Using a general methodology, we nd no evidence that the timing of
earnings news has any benet for rms stock returns. In fact, in many cases we nd
rms attempting to engineer positive earnings surprises by beating down expectations
only to discover that their eorts are counterproductive. Our results appear to overturn
the ndings of previous authors who, using less general methodologies, have suggested
that rms can boost their stock returns by getting bad news out early. Our results
are robust across time periods, for dierent scaling factors on earnings revisions and
surprises, when controlling for rm size and growth prospects, and when conditioned
on past earnings news.
We thank Eli Bartov, Mark Carey, Robert Hauswald, Andreas Lehnert, Michel Robe, and the par-
ticipants at the 2003 Western Finance Association Meetings for helpful comments and suggestions, and
Eric Richards for excellent research assistance. This paper represents the views of the authors and does
not necessarily represent the views of the Federal Reserve System or members of its sta. Please address
correspondence to (Downing): Federal Reserve Board, Mail Stop 89, Washington, DC 20551. Phone: (202)
452-2378. Fax: (202) 728-5887. E-Mail: [email protected]. (Sharpe): Federal Reserve Board, Mail Stop 89,
Washington, DC 20551. Phone: (202) 452-2875. Fax: (202) 728-5887. E-Mail: [email protected].
1 Introduction
Over the last decade, corporate chieftains seem to have become increasingly preoccupied
with their quarterly nancial results and whether those results meet their equity analysts
forecasts. Indeed, both market observers and academic studies have pointed out an appar-
ent tendency for corporate managers to guide analysts overly optimistic earnings forecasts
downward in advance of the ocial release, so that the rms are able to meet or beat Wall
Street expectations on the release date.
It is easy to understand managements obsession with meeting Wall Street estimates in
light of the punishment frequently meted out to the stocks of companies whose quarterly
results fall short of forecasts. What is more dicult to understand is how rms could benet
from managing down current quarterly forecasts by preannouncing bad news several days
or weeks before their nal results are released. If, at the end of the day, the total news
is the same, then any benet to the stock price at the earnings announcement should be
entirely oset by the earlier negative price impact at the time of the warning, rendering
the cumulative return insensitive to the timing of the news. This standard ecient markets
view, however, seems at odds with popular perceptions. Moreover, some recent academic
studies also conclude that managing expectations down ahead of bad news reduces the total
stock price impact of the news.
In principle, testing the hypothesis that rms can boost their near-term stock prices
by managing expectations should be straightforward. Controlling for the total earnings
information revealed over the period in question the gap between realized earnings and
the beginning-of-quarter forecast (the total forecast error) one can test whether the
timing of information revelation matters for the cumulative stock return over that period.
While a number of recent studies have attempted to implement this testing strategy, the
results are somewhat contradictory and the methodologies may not be robust.
In this paper, we examine the stock price benet of meeting or beating expectations
using a general, yet intuitive, approach. Our methodology most closely parallels Kasznik
1
and McNichols (2002) and Bartov, Givoly and Hayn (2002), both of whom measure interim
earnings news using revisions to analyst forecasts. Kasznik and McNichols (2002) gauge
the rewards to meeting analysts annual earnings forecasts by testing whether meeting (or
beating) those forecasts has a positive incremental eect on stock price, while controlling for
the total information revealed over the year. Indeed, they nd a positive incremental eect
of meeting the expectations at the time of the earnings announcement. Bartov et al. (2002)
conduct a similar experiment, but focus on quarterly earnings. They also nd that meeting
expectations has a benecial stock price eect, even after controlling for the total earnings
news over the quarter, including the day of the report.
A clear implication of these ndings is that earnings news released during the rms
performance period, that is, during the year or quarter, has a smaller stock price impact
than the same news released around the time of the actual report. This suggests that rms
can boost their stock prices by releasing negative news early, when price responses are lower,
while keeping any good news under wraps until the earnings report, when price responses
are larger.
Like these and a few other studies that have appeared recently in the literature, in this
paper we estimate the eect of quarterly earnings news on quarterly abnormal stock returns
by splitting quarterly total forecast errors into two contiguous pieces: (i) a forecast revision,
dened as the dierence between analysts forecasts early in the quarter and their forecasts
three days before the earnings announcement; and (ii) an earnings surprise, dened as the
dierence between the three day forecast and actual reported earnings. We then estimate the
eects of these forecast revisions and earnings surprises on the cumulative abnormal return
over the period.
The most important methodological dierence here is our use of nonparametric esti-
mation, which allows for a wide range of abnormal return response functions. Given the
potential nonlinearities that might underpin the relation between earnings news and stock
returns, we argue that careful consideration should be given to the form of the assumed
2
response function. Most of the previous studies have assumed that the response of stock
returns to earnings information is linear, with the possible exception of a discontinuity at
an earnings surprise of zero. Indeed, under any number of possible nonlinearities, such
regressions would be prone to incorrectly accept the hypothesis of a discontinuity at zero.
To estimate the abnormal return function, we employ the locally weighted least squares
(loess) method (Cleveland (1979), Cleveland and Devlin (1988)), which allows for a wide
range of possible functional forms. Moreover, under standard assumptions on the error term,
the statistical properties of the locally weighted least squares estimator are well approximated
by those of the the ordinary least squares estimator. The principal drawback to loess is
that it is a computationally and data intensive procedure, but given recent advances in
computer speed and our very large dataset, these drawbacks are signicantly mitigated in
our application. We report our results in the form of three-dimensional plots of the abnormal
return on the vertical axis against the forecast revision and the surprise on the horizontal
axes, thereby allowing one to examine the estimated tradeo that rms face at a variety of
points in revision-surprise space.
A second important methodological dierence between our study and previous work is
that we focus on the econometricians choice of the preannouncement period, and suggest
that revisions early in the quarter might reect the previous quarters news. If analysts do
not fully incorporate the previous quarters earnings announcement into their newly updated
or reconrmed forecasts, but the stock price does immediately incorporate the information,
then revisions to these early-quarter forecasts might not convey as much information to the
market as revisions that follow company guidance later in the quarter. This would create
a spurious asymmetry in the magnitude of stock price responses to forecast revisions and
earnings surprises.
Finally, we examine the choice of the scaling factor applied to the forecast revisions
and surprises a choice that we argue could inuence the results. It is conventional in
accounting studies to normalize by beginning-of-period stock price, which reduces problems
3
with outliers. We argue that, in theory, expected earnings (or book value) is a preferable
measure. We nd that the expected earnings scaling factor produces ts that are slightly
superior, in a statistical sense, to the ts produced by the price scaling factor.
In contrast to previous studies, we do not nd any short-term stock price benet to
preannouncing bad news. In other words, we nd little or no dierence in the sensitivity of
stock returns to early forecast revisions and earnings surprises. This conclusion appears to
be robust across practically the entire range of the data. In particular, in most cases we do
not even see a benet from nudging analysts forecasts so that the earnings surprise is zero
or slightly positive rather than slightly negative. Finally, we look at whether these results
obtain when we condition on the size of the rm and on the rms growth prospects as
measured by analysts long-term growth forecasts. While we do nd that the stock prices of
high-growth rms, particularly small, high-growth rms, tend to be much more sensitive to
quarterly earnings news than those of low-growth rms, we again do not nd any signicant
asymmetries in their sensitivity to news released early versus news released at the earnings
report.
This paper is organized as follows. In the next section, we provide an overview of this
rapidly expanding literature. Section 3 describes the data in detail and discusses our empir-
ical methodology, and section 4 lays out our results. The nal section concludes.
2 Previous Literature
Over the past decade, the consensus-meeting game played by corporate management and
equity analysts seems to have become a dominant feature of the corporate reporting land-
scape. In general, rms can meet over-optimistic expectations in one of two ways. They can
manage their nancials in such a way as to boost the earnings they actually report, or they
can provide guidance to analysts well before earnings are actually reported, causing analysts
to immediately mark down their forecasts. Our analysis focuses on the latter behavior.
4
Early evidence on the asymmetric nature of management disclosures is provided by Skin-
ner (1994), who found that, more than a decade ago, 67 percent of early quarterly disclosures
conveyed bad news. Kasznik and Lev (1995) show that this asymmetry did not merely reect
the state of forecasts relative to the economy, but a greater propensity by management to
divulge signicant earnings news early when that news was negative. Moreover, the propen-
sity to avoid the negative announcement-day surprises appears to have become increasingly
pervasive over the last decade. For instance, Matsumoto (2002) shows that in a large and
growing percentage of cases where quarterly reports matched or even beat expectations,
those reports were negative surprises relative to where analyst forecasts stood one to two
months prior to the report (see also Burgstahler and Eames (2002)).
Media reports often presume that preannouncements are aimed at softening the impact of
bad news on stock prices, but the underlying motivation remains a subject of growing debate
in the academic literature. Skinner (1994) and other early research on the topic emphasizes
that the threat of litigation gives rise to an asymmetry in the penalty for reporting signicant
downside surprises. A number of authors have oered behavioral rationales, such as the
presumption that analysts are more embarrassed when a company that they follow reports
a negative surprise than when results top their forecasts. A third type of rationale invokes
signaling: By preannouncing bad news, rms might signal that they have some understanding
of the situation. In particular, Liu and Yao (2003) argue that rms preannounce bad news to
signal they have better growth prospects than rms that dont preannounce bad news. This
last rationale, if not the others, would seem to suggest that the consensus-meeting game is
designed to boost (or perhaps just bolster) the rms stock price.
Some recent studies propose more insidious motivations. For example, Aboody and
Kasznik (2000) oer evidence that managers are motivated to make bad news public or hold
back good news prior to receiving installments on executive stock option grants. By moving
forward and perhaps exaggerating its negative stock price impact, preannouncing bad news
lowers the strike price on newly-granted stock options, thereby raising the potential value
5
of the options to managers. In contrast to previous explanations, this rationale does not
imply that prereleasing negative information benets the rms stock price in the short- or
long-run; rather, it merely pulls forward in time any downward price adjustments.
In a similar vein, Richardson, Teoh and Wysocki (2003) point out that the window
during which insiders can sell shares, and when rms tend to issue shares, usually follows
ocial earnings releases. If management believes that the market temporarily overreacts to
bad news, or that the market reacts less to bad news when it is disseminated prior to the
earnings report, then preannouncing such news well before both the report date and the
window for selling shares could bolster the price that managers receive on sales of shares to
the public. A similar argument, which may be more easily reconciled with market eciency,
is that preannouncing bad news might simply reduce the variance of the price received on
post-report share sales, by providing more time for the information to be digested.
While there is little agreement on the primary motivation behind the consensus-beating
game, there does appear to be mounting evidence that playing this game has a positive
impact on stock prices. Such evidence has taken one of two forms. One approach to gauging
that impact is by analyzing valuations (the level of stock prices) to infer whether rms that
tend to meet consensus forecasts on the report date also tend to be more highly valued
(Chevis, Das and Sivaramakrishnan (2002), Liu and Yao (2003)). This type of evidence,
though highly suggestive, must be viewed with at least some skepticism, as it is dicult
to control for rm characteristics and insure that the true direction of causation is not the
reverse. In particular, it is dicult to control for the likelihood that highly-valued growth
rms are more prone to play the consensus-beating game. Indeed, those rms should be
more motivated to do so if, as suggested by Skinner and Sloan (1999), they are penalized
disproportionately when their reported earnings do fall short of consensus forecasts.
The most direct evidence on the stock price benets of playing the consensus-beating
game comes from studies that analyze stock returns. One of the rst studies to try gauging
the eect of company preannouncements on stock prices was Kasznik and Lev (1995), who
6
identify discretionary management disclosures via a NEXIS News search. They analyze
fourth-quarter earnings announcements from 1988-1990, focusing only on observations with
substantial total forecast errors between actual earnings and forecasts 30 days after the
previous quarters earnings announcement. Controlling for the total forecast error, they nd
no evidence that issuing an early disclosure boosts cumulative returns. In fact, among rms
with substantial negative forecast errors, they nd that issuing an early disclosure has a
negative eect on the cumulative returns measured over a narrower window.
More recently, Soer, Thiagarajan and Walther (2000) analyze the stock returns of com-
panies identied by First Call as having issued quantitative preannouncements no earlier
than two weeks prior to quarter-end. They nd that, even after controlling for the total
forecast error (the dierence between actual earnings and the forecast at the time of the
preannouncement), having a negative earnings surprise on the earnings announcement has a
negative eect on total-period stock returns. Moreover, they nd that stock prices are more
sensitive to the amount of negative news when it is released at the earnings announcement,
suggesting that rms can reduce the impact of negative news by preannouncing it.
These ideas are further tested in the study by Bartov et al. (2002), henceforth BGH,
who analyze roughly three-month cumulative returns for all rms whose quarterly earnings
are forecasted by analysts tracked by Thompson/First Call. Again, controlling for the size
of the total forecast error, they test whether cumulative stock returns are aected by the
timing of earnings news. Their methodology is similar in spirit to the analysis of annual
earnings surprises by Kasznik and McNichols (2002). In both studies, news is gauged solely
by changes in analyst estimates, and in both cases, it is found that the cumulative returns
on stocks of rms with bad news (negative forecast errors) are higher when the bad news
is reected in forecasts before the earnings announcement. The implication is that rms
can dampen the eects of bad news by driving down analyst forecasts prior to the earnings
report, through preannouncements or quieter means.
1
1
Firms scope for inuencing analysts forecasts by quieter means was signicantly limited following
October 23, 2000, when the Securities and Exchange Commission adopted Regulation FD (Fair Disclosure)
7
BGH recognize the potential for nonlinearities and provide relatively compelling evidence
using dierence-in-means tests. In particular, they divide observations into buckets according
to the size of the total forecast error. Among the set of observations falling within any given
range of total forecast errors (e.g., -5 to 0 percent), they compare the average abnormal
return for observations where there is a negative surprise on the report date to the average
return among those where there is a positive surprise. Our approach diers from BGH in two
potentially important respects. First, our methodology uses a continuous distance metric for
dening which observations are close to one another in the sample space. Second, among
observations within a given neighborhood, our estimation strategy allows for a slope, as well
as an intercept, in estimating the abnormal return function. While this should make our
estimates less biased, the potential downside is a loss of precision.
Venkatachalam and Wang (2000) recognize a need to allow for nonlinearities, but they
estimate an earnings response function that only allows for some select breaks in the linearity
assumption, including asymmetries in the response to positive and negative information.
Their results partially conrm those of BGH, but suggest a more complicated story in which
the benets of lowering expectations are not uniform. Still, these inferences may be just as
sensitive to their parametric restrictions, which presume linearity over large ranges of the
data.
Our approach to the question essentially amounts to a generalization of the common
hypothesis in these previous studies: Is the size of the cumulative stock return a function of
not only the amount of earnings news, but also of the timing of that news? For instance,
does bad news have a smaller negative eect if that news is released some days or weeks
ahead of the actual earnings announcement? As in the more recent studies, we use analysts
earnings forecasts to measure market expectations. Under this approach, current-quarter
revisions to analysts forecasts are assumed to reect the timing of earnings news released
which addresses selective disclosure. The regulation provides that when an issuer (rm), or person acting
on its behalf, discloses material non-public information to securities market professionals and/or holders of
the issuers securities, it must make public disclosure of that information.
8
by the rm, either publicly or privately.
3 Data and Methodology
3.1 Data Construction and Measurement Issues
Our study examines U.S. rms quarterly earnings reports from 1987 through 2001. Data on
both equity analysts forecasts of earnings per share and actual earnings per share (EPS) are
drawn from the I/B/E/S history and analyst detail les. For each rm-quarter observation,
we compute the average of analysts quarterly EPS forecasts, measured in dollars per share,
at three points in time: (i) 7 days after the previous quarters report (or about twelve weeks
before the current-quarter report date); (ii) 42 days (or six weeks), before the current-quarter
report date; and (iii) 3 days before the report date. To avoid using stale forecasts, average
forecasts are computed using only those forecasts that were issued or conrmed after the
previous quarters earnings report. To lter out observations where information timeliness
may be a problem, we exclude rm-quarters in which earnings are not reported within 90
days after quarter-end. In addition, we exclude observations in which the report is not
issued between 8 and 16 weeks after the previous quarters earnings report (where the mode
is about 13 weeks).
These data are used to construct our main information variables. We dene the total
forecast error as the dierence between actual quarterly EPS, revealed on the announcement
date, and our earliest consensus forecast, F0 in gure 1. Similar to BGH, we split the total
forecast error into two components: (i) the surprise, dened as the dierence between actual
earnings and the consensus forecast 3 days earlier, F
2
; and (ii) the forecast revision, dened
as the dierence between the 3-day forecast, F
2
, and the early-quarter consensus forecast,
F
0
.
A key methodological question concerns the timing of the early forecast, F
0
: How early
should this measurement be taken? BGH measure this as early as 3 days after the previous
9
quarters announcement. However, early in the quarter it is possible that analysts have not
fully incorporated the ramications of the previous quarters ocial earnings release into their
updated or reconrmed forecasts, even if the stock price has incorporated that information.
If this were the case, then revisions to these forecasts may not convey as much information to
the market (where the news has already been digested) as revisions that follow new company
guidance later in the quarter. This would create a spurious asymmetry in the magnitude of
stock price responses to forecast revisions and announcement-day surprises.
To address this concern, we construct an alternative measure of the initial forecast re-
vision, equal to the average forecast as of six weeks (42 days) prior to the actual earnings
announcement, denoted by F
1
in gure 1. In this case, the revision is the dierence between
F
1
and F
2
, while the surprise is dened as before. For the typical rm, F
1
would fall in
the middle of the third month of the quarter, about the time that most managers would
have an accurate picture of the rms performance over the rst two months of the quarter.
Also, most warnings tend to come near the end of the quarter or shortly thereafter, so this
more abbreviated forecast revision period should capture most of the information released
in pre-announcements (Soer et al. (2000)).
A second measurement issue that we consider is how to best scale earnings revisions and
surprises. The most common scale factor in the literature is the rms beginning-of-period
stock price. This scale factor is convenient because the stock price is always positive and
is rarely small relative to the numerator. From an analytical perspective, however, this
approach is less satisfying, and we also argue that this scale factor is likely to distort the
relative sizes of earnings revisions and surprises across rms. In particular, it has been argued
that the stock return of high growth, high price-to-earnings (PE) ratio rms should be more
sensitive to any given earnings surprise compared to slower growing, low-PE rms. However,
all else equal, scaling earnings revisions by stock prices will make the news on high-price
rms appear smaller than the same news on low-price rms. If so, this scaling would induce
measurement error that would reduce the apparent explanatory power of earnings news.
10
Two alternative scale factors that we consider are the level of realized earnings-per-
share, which converts the revisions and surprises into percentage terms, and book value
per share, which converts them into returns on equity. While these measures might be
preferable analytically and theoretically, they produce numerical diculties when earnings
or book value are negative or near zero. To implement these scale factors, we use their
absolute values, and delete observations for which the value of the scale factor is close to
zero. For the EPS scale factor, we omit observations in which actual EPS is 5 cents or
less in absolute value, denoting the resulting variable by |EPS|. In the case of book value,
we omit observations where the absolute value of the expected quarterly return on equity
was greater than 25 percent (an annualized expected return of 100 percent).
2
Because the
book value scaling factor produced results that were qualitatively indistinguishable from the
|EPS| scaling factor, in what follows we discuss only the results based on the |EPS| and price
scaling factors.
The earnings data are linked with stock price data drawn from CRSP. For each rm-
quarter, we calculate the cumulative return on the rms stock between the day of the initial
forecast, F
0
, through the day after the release of the current quarters earnings. To compute
abnormal returns, we calculate the cumulative return on the S&P500 Composite index over
the same period and subtract this from the rm-level return. Although not shown in the
paper, we also calculated abnormal returns using estimated betas in a traditional single-
factor market model. However, both the qualitative and quantitative results using these
measures were virtually indistinguishable from the results reported here.
3
2
We drew the book value data from Compustat.
3
We constructed betas for each rm-quarter using daily stock returns for the 250 trading days preceding
the rst calculation of the mean EPS forecast for each rm, matched with daily returns on the S&P 500
index (the market return) over the same time period. In other words, for each rm we compute quarterly
betas on rolling one year samples of the rms stock returns and S&P 500 returns. The principal reason that
beta-adjusted returns do not change our results appears to be the fact that betas contain little predictive
power for rm-level returns, particularly for smaller rms.
11
3.2 Sample Statistics
After merging the I/B/E/S, CRSP, and Compustat data, constructing the revision, surprise,
and abnormal return variables, and applying our data timeliness criteria, we have 134,098
rm-quarter observations (before scaling revisions and surprises). For most of our analysis,
we split the data into two subsamples, an early sample spanning 1987-1995, and a late sample
spanning 1996-2001. Doing so should provide some indication of any longer-term behavioral
changes. Because coverage of smaller rms has expanded over time, there are many more
observations per quarter in later years.
We apply some additional criteria to eliminate outliers. We remove rm-quarters with a
beginning-of-period stock price less than 3 dollars, as such observations are likely to produce
very volatile and highly idiosyncratic returns. As mentioned earlier, for the earnings-scaled
analysis, we eliminate observations in which quarterly EPS is 5 cents or less in absolute
value. Lastly, we trim out observations for which any of the variables (revisions, surprises,
or abnormal returns) have extreme values, dened as values in the top or bottom 2 percent
of the variables empirical distribution. After these renements, we are left with a total of
100,437 observations in the sample using the |EPS| scaling factor, and 111,111 observations
for the sample using the price scaling factor.
In order to provide a sense of some of the qualitative features of our data, gure 2 provides
scatter plots depicting the joint distribution of 12-week earnings revisions and earnings
surprises, scaled by |EPS|. Panel A depicts the joint distribution over the period 1987-1995,
while panel B shows the distribution for the period 1996-2001. In the early period, revisions
range from -0.94 to 0.30 (-94 percent to 30 percent), while in the late period, revisions
range from -108 percent to 21 percent. The distribution of surprises in the early period is
more skewed toward negative surprises than in the late period. These features of the data
are suggestive of increased eorts over time on the part of analysts to keep their forecasts
current, and/or increased eorts on the part of rms to manage down expectations so as to
12
avoid negative surprises.
4
Turning to a quantitative description of the data, table 1 displays univariate statistics
for our measures of revisions, surprises, and abnormal returns. The table displays the 25
th
,
50
th
, and 75
th
percentiles for the variables, plus the interquartile ranges, with all values
multiplied by 100 (which converts the dependent variable and the |EPS|-scaled revisions
and surprises into percent values). Panel A shows statistics for the early and late samples
when the revisions and surprises are scaled by |EPS|, while panel B shows sample statistics
when we scale by price. The rst column in the upper left box of panel A shows some of
the distributional characteristics of abnormal returns, the dependent variable, in the early
period for the 12-week revision subsample. As shown, fty percent of the observations on
abnormal returns lie between -7.90 percent and 7.43 percent, and the median value is -0.18
percent. In the late period, abnormal returns appear more volatile, with the 25
th
percentile
at -13.00 percent and the 75
th
percentile at 10.17 percent.
In both the early and late samples, there is a clear asymmetry in the distribution of revi-
sions, with negative revisions being much larger and more plentiful than positive revisions.
In the early sample, the 25
th
percentile |EPS|-scaled revision equals -5.15 percent, whereas
the 75
th
percentile is 1.67 percent. Although the late sample also shows this asymmetry,
the distribution is notably tighter, implying that that quarterly forecasts have become more
accurate in recent years.
Moving down panel A to the statistics for the 6-week forecast revisions, we nd this
narrower measure to be much more tightly distributed compared to the 12-week revisions,
with a higher proportion of zeros. The 25
th
percentiles fall to -1.71 percent and -1.14 percent
in the early and late periods, respectively, while the median 6-week revision is zero in both
subsamples.
More obvious here than in the scatterplots is the strong positive skew of surprises, consis-
tent with the ndings of previous studies, such as Richardson et al. (2003), which document
4
The striations evident in the data reect rounding and our cuto on EPS values. We discuss the boxes
below.
13
analysts generally positive forecast bias that disappears as the earnings announcement date
nears. In the early sample, the median surprise is 1.08 percent, while in the late period,
it is 2.34 percent. The positive skew in the distribution of surprises is most evident in the
late sample, suggesting greater eort by rms to avoid negative surprises in recent years,
consistent with the ndings in Matsumoto (2002).
Turning to the price-scaled data in panel B, the qualitative features of the statistics dier
only slightly from panel A. The small dierences in the distributions of abnormal returns
owe to the ltering out of observations with tiny earnings-per-share values.
The partial correlations amongst the variables can be inferred from table 2, which shows
the results of simple linear regressions estimated on the various subsamples, with abnormal
return as the dependent variable. All three information variables the two partly over-
lapping revision variables and the surprise are included as regressors. The regression R
2
values range between 4.8 and 6.2 percent, values comparable to those for similar regressions
in previous studies. There appears to be little dierence in qualitative comparisons between
the results for the |EPS|-scaled and the analogous price-scaled regressions.
Focusing on the |EPS|-scaled regressions, in both the early and late subsamples, all three
information variables are signicant, suggesting that the stock price eects of late-quarter
revisions (those during the last six weeks before report) tend to be larger than the eects of
revisions earlier in the quarter. In the early sample period, the coecient on the 12-week
revision is only 0.05, while the marginal eect of the 6-week revision is 0.23; this would imply
that a revision during the latter six weeks has a total eect of 0.28 (0.23+0.05). Notably, the
coecient on the surprise is only 0.16, suggesting that surprises have a substantially smaller
eect on returns compared to late-quarter revisions. However, we view these results as at
best suggestive; given the potential for nonlinearities in the relationship between returns
and revisions and surprises, they may not hold up over key portions of the revision-surprise
space.
The late period results are similar, though the eects of our information variables appear
14
to be larger. The coecient on 12-week revisions is substantially larger, at 0.21, perhaps
reecting increased attentiveness toward early-quarter forecasts in more recent years. In this
sample, the total estimated eect of forecast revisions during the second 6-week interval is
0.35 (0.21+0.14). Finally, the coecient on surprises, at 0.28, is nearly twice as large as in
the earlier years.
3.3 Methodology: Locally Weighted Least Squares
Our basic regression specication is given by:
Abnormal Return
n
= f(Revision
n
, Surprise
n
) +
n
, (1)
for n = 1, 2, . . . , N, where N is the number of rm-quarter observations (note that we
have pooled the quarterly data and dropped the time subscript for notational ease). The
Abnormal Return on a rms stock is the cumulative return over the roughly 12-week
period ending one day after the earnings report, less the cumulative return on the S&P500.
The Revision and Surprise are dened as described above.
5
The random error
n
is
assumed to be normally distributed with zero mean and constant variance
2
, and is further
assumed to be uncorrelated with revisions and surprises.
Theory provides little guidance on the functional form of f(), so in order to allow for the
greatest range of possible functional forms, we adopt a nonparametric estimation approach.
Specically, we employ locally weighted least squares (loess) to estimate f() (Cleveland
(1979), Cleveland and Devlin (1988), Cleveland, Devlin and Grosse (1988)). Loess is es-
sentially a method for smoothing scatterplots by means of the local tting of low-order
polynomials. At a given point in the revision and surprise space, local tting is achieved
with a weighting scheme that down-weights data points that are relatively distant from the
given tting point. Compared to perhaps more familiar kernel regression techniques, such
5
In our notation, we do not explicitly indicate the scaling factor; in the discussion of our results, we will
always make clear which scaling factor applies.
15
as the Nadaraya-Watson estimator (Nadaraya (1964), Watson (1964)), loess is typically less
biased on the boundaries of the data and in other situations where the data are asymmetri-
cally distributed in the local regression sample (where by local regression sample we mean
the points with non-zero weight in the local t see Hastie and Loader (1993)). More-
over, the estimator enjoys a number of convenient statistical features by virtue of its close
association to the ordinary least squares estimator.
An important element of the loess methodology is the denition of the weighting function.
Following Cleveland (1979), we employ the tricube weight function:
W(x) =
_
_
(1 |x|
3
)
3
for |x| < 1;
0 for |x| 1.
(2)
As shown in Devlin (1986), the tricube weighting function improves certain approximations
to the distributions of some of the statistics associated with the loess estimator. Denoting
by h
i
the distance from x
i
to its r
th
nearest neighbor, for each data point n = 1, 2, . . . , N we
construct the weights:
w
n
(x
i
) = W
_
x
n
x
i
h
i
_
. (3)
As can be seen by examining equations (2) and (3), the r
th
nearest neighbor and all points
more distant from x
i
receive zero weight.
The estimates

i,0
and

i,1
are computed by minimizing the sum of squared residuals:
N
n=1
w
n
(x
i
) (y
n

i,0
+
i,1
x
n
)
2
. (4)
More independent variables can, of course, be included in equation (4), if called for in the
application at hand. As we move across the tting points x
i
, we re-compute the weights
assigned to each of the data points included in the regression, producing a series of estimates
i,0
and

i,1
for i = 1, 2, . . . , N.
Like all other nonparametric techniques, an application of loess requires that the econo-
16
metrician decide on the degree to which the precision of the estimate (bias) is to be traded o
against smoothness (variance). In general, the desired amount of smoothing is application-
specic (Mallows (1973)). We based our smoothing parameter selections on two standard
selection methods. First, we performed generalized cross-validation (GCV) on each sub-
sample in order to select a smoothing parameter (H ardle (1990)). Second, we computed
M-statistics across a range of smoothing parameter settings. As discussed in Cleveland and
Devlin (1988) and summarized in the appendix, the M-statistic is an extension of the C
p
procedure of Mallows (1973) for choosing a subset of independent variables based on esti-
mates of the mean squared error for each subset. We used graphs of M-statistics (M-plots) to
gauge the tradeo between bias and variance embodied in the smoothing parameter selected
by GCV. In general, the M-plot analyses conrmed the GCV smoothing parameter settings:
the M-plots revealed that the GCV parameters were consistent with a null hypothesis of zero
bias. In cases where there was divergence between the GCV parameters and the optimal pa-
rameter suggested by the M-plot analysis, we picked the lowest smoothing parameter (least
smoothing) that would accept a null hypothesis of zero bias at the traditional 95 percent
level, so as to reveal nonlinearities in the abnormal return response function.
4 Empirical Results
We begin by estimating the eects of 12-week forecast revisions and earnings surprises, both
scaled by |EPS|, on abnormal returns in the early sample period (1987-1995). Figure 3 shows
four sets of estimation results, each based on a dierent smoothing parameter. The upper
left plot depicts the estimated surface for a smoothing parameter setting of 0.15, meaning
that each local regression uses 15 percent of the available data. At the other extreme, the
bottom left plot shows the estimated surface based on a smoothing parameter of 0.75. We
display the surfaces over a portion of revision and surprise space that contains most of the
data. For this subsample, the displayed surfaces are on a grid of points laid over the box
17
drawn in panel A of gure 2.
6
The rest of the surface is omitted because the quality of the
t deteriorates as we move toward the fringes of the data.
Each surface shows the predicted abnormal return in the relevant revision-surprise space.
As one would expect, the surface tends to be highest where both the revision and surprise
are positive and relatively large. Casual observation suggests that the predicted abnormal
return is an increasing function of the revision and surprise over most of the sample space.
But the results also indicate substantial nonlinearities; in particular, the eect of a change
in the revision or surprise appears to be largest when both are close to zero. Of course,
the degree of nonlinearity is reduced when the surface is estimated with a high smoothing
parameter, but the GCV smoothing parameter for this sample is low, about 0.15.
Figure 4 illustrates the results from the same estimation procedures run on the later
sample period (1996-2001).
7
These surfaces clearly slope upward over the whole range of the
data in both the revision and surprise dimensions, and dier from the early sample in two
notable respects. First, there appears to be less nonlinearity: changes in either independent
variable have a noticeable price impact over the entire range of the independent variables,
rather than eects that are concentrated near (0,0). The optimal smoothing parameter
reects this fact; our selection methodology picked an optimal smoothing parameter of 0.6,
much higher than in the early sample. Second, while somewhat dicult to discern, the range
of predicted abnormal returns in this sample (the vertical range of the surface) is wider than
that in the early sample, implying that the stock price sensitivity to earnings surprises has
increased over time.
A useful tool for gauging the relative eects of revisions and surprises is the contour plot,
a two-dimensional plot of iso-return lines in revision-surprise space. Figure 5 provides such
a contour plot for the early-sample estimates shown in gure 3 (at the optimal smoothing
parameter setting of about 0.15). The iso-return lines (the solid curved lines) reect 1
6
In each case, the box over which the surfaces are displayed covers the 4
th
through 96
th
percentiles in
the revision dimension and the 6
th
through 94
th
percentiles in the surprise dimension. Twenty points in
each dimension are plotted, for a total of 400 points on each surface.
7
The surfaces are displayed over the box drawn in panel B of gure 2.
18
percentage point steps: moving from one iso-return line to an adjacent line corresponds to
a 1 percentage point change in abnormal return. The highest iso-return lines are in the
upper right-hand corner, where both the revision and surprise are positive. The distance of
the iso-return lines from one another indicates the return gradient in a particular direction;
more tightly packed contour lines indicate a larger eect of earnings information on abnormal
return.
If the timing of information matters, then changing the decomposition of a given total
forecast error into surprise versus revision would put one onto a dierent iso-return line. In
order to gauge the trade-o, we overlay three iso forecast error loci, represented by the
straight dashed lines. Any given iso-forecast error locus represents the state faced by the
rm, characterized by (i) the initial expectations at the beginning of the quarter and (ii)
the earnings it will ultimately report. A particular position along that iso-forecast error line
represents an information release policy by the rm. For instance, the lowest line, labeled -10
percent, represents the state in which the early-quarter analyst forecast, F0, is 10 percent
higher than the actual earnings, which the company will ultimately report in its earnings
release after quarter-end. The coordinates (0,-10) on this line represent the outcome in
which no information is released early and a -10 percent surprise is revealed on the earnings
announcement date. Alternatively, the coordinates (-10,0) represent a -10 percent early
revision and zero surprise; here, all of the information was revealed early, perhaps via a
preannouncement. Another possible outcome is (-20, 10): overly pessimistic information is
preannounced, prompting a -20 percent forecast revision, and actual earnings then exceed
the pre-report forecast by 10 percent.
The rst key empirical result of our analysis is seen by comparing the slope of the iso-
forecast error lines with the slopes of the iso-return lines, or information policy lines.
Forecast revisions have smaller price eects than surprises if the information policy lines
are steeper than the iso-return lines. In that case, a rm can achieve a higher return by
releasing unfavorable information early, that is, by choosing a point to the northwest on
19
the information policy line. Indeed, this is what we nd in the region near (0,0), where the
data concentration is highest. Thus our initial set of estimates are consistent with previous
results suggesting that rms might be able to engineer higher returns by beating down
expectations early on and then releasing good news to the market on the announcement
date. In particular, this result is consistent with the ndings of Bartov et al. (2002) who
use dierence-in-means tests on a similar sample and similar denitions of revisions and
surprises.
Figure 6 depicts the contour plot that results from running the same estimation proce-
dure on the late sample, spanning the period 1996-2001. Here, we are led to the opposite
conclusion. The picture shows that the rms information policy lines either run parallel to
the iso-return lines or even, in some data-rich areas of the design space, at a shallower slope.
For instance, the zero-percent forecast error line crosses over to lower iso-return lines when
moving northwest from (0,0) to (-10, 10).
Before speculating on why the two time periods might dier, we examine the sensitivity
of the results to our denition of the forecast revision period. As noted earlier, there tend to
be relatively few earnings preannouncments early in the quarter (subsequent to the previous
quarters report). Hence a measure of the forecast revision based on early-quarter forecasts
could produce a downwardly biased estimate of the stock price eects of analyst revisions
induced by preannouncments. To eliminate this potential source of bias, we re-estimate the
return response surfaces using the 6-week forecast revision in place of the 12-week revision.
Figures 7 and 8 show the contour diagrams with the results for the early and late sample
periods, respectively. Here, in both samples, we nd no evidence of a favorable tradeo
from releasing negative information early. In fact, the iso-return contours in both cases tend
to be a bit shallower than the information policy lines, which implies that the total eect
of earnings news on returns may even be smaller in cases where rms kept the negative
information under wraps until the earnings announcement.
Clearly, the estimates using the 6-week forecast revision produce no evidence to suggest
20
that rms can bolster their stock prices by preannouncing bad earnings news early in order
to meet or beat expectations when the earnings report is released. How do we reconcile
these results and the somewhat ambiguous conclusions drawn based on the 12-week revi-
sion? First, as argued earlier, early-quarter forecasts by analysts may not reect all of the
information revealed to the market in the previous quarters nancial report. With sim-
ilar eect, even if investors have not rened their own views on current-quarter earnings,
they still might heavily discount analysts early-quarter forecasts. Either way, movements in
analyst estimates earlier in the quarter might not accurately reect investor convictions.
Still, there remains the question of why the earlier 12-week revisions appear to have had
more price impact in recent years, as implied in Figure 6. This might be rationalized by
the observation that analysts earnings forecasts have garnered increased attention over the
1990s, evidenced for instance by the increased use of analysts forecast revisions as a factor
in stock selection during this period (Kirschner and Bernstein (2003)). As their forecast
revisions have garnered more attention in recent years, analysts presumably felt stronger
incentives to exert greater eort in calibrating their early-quarter forecasts.
4.1 Standard Errors
The statistical precision of our conclusions is perhaps best cast in terms of the accuracy
with which we can resolve the location of the contour lines on our contour plots. Hence,
in terms of statistical precision, we are primarily concerned with the standard errors on the
tted values (the distribution of the standardized residuals) as opposed to the individual
coecient estimates.
Under the loess theory, the distribution of the standardized residuals is well approxi-
mated by a t-distribution. However, calculation of the degrees of freedom is computationally
expensive (see Cleveland et al. (1988)), requiring the inversion of a matrix with rows and
columns equal to the number of observations. Moreover, this matrix must be built up one
row at a time because, in essence, there is a dierent set of regression coecients at each
21
tted point. To make these calculations we developed specialized software based on the
Scalapack software library.
8
Table 3 provides calculations of the precision of our t for the late sample period.
9
We
display the width of 95 percent condence intervals around the tted values at various points
on the solution surface. Panel A displays the condence interval widths when we use the
12-week revision. As can be seen, in the center of the data (near the point where both the
revision and surprise are zero), the condence intervals have a width of about 1.3 percentage
points of abnormal return. When we move to the outer fringes of the data, where the
observations are far less concentrated, the condence interval widths range from 2.1 to 3.7
percentage points. Comparing these results to those in Panel B, we nd that the widths of
the condence intervals in the center of the data are comparable when we use the 6-week
revision, but at the fringes the condence intervals are somewhat wider. Taken together,
these results indicate that a two percentage point move, that is, a move across two contour
lines, is a statistically signicant move in the area where the data is densely distributed.
This suggets that, in gures 6, 7, and 8, the perverse tradeos that we nd for rms moving
along their information policy lines are only statistically signicant for fairly sizable moves,
if at all. Our results on statistical precision also indicate that, as one moves further away
from the center of the data, the contours are not resolved with as much statistical precision,
suggesting some caution is required in interpreting the shape of the contours in regions where
the data are relatively sparse.
4.2 Robustness and Sub-Sample Analysis
This section explores the robustness of our qualitative results, focusing in particular on
the ndings for the 6-week revision period. As discussed earlier, our main concern is the
sensitivity of the results to the choice of the scaling factor for the earnings news. To examine
8
The Scalapack library contains pre-programmed Fortran and C routines for carrying out basic linear
algebra computations on a network of workstations.
9
Calculations for our other ts reveal similar degrees of precision, and are omitted.
22
this issue, we re-estimate the early- and late-period contours with the revision and surprise
variables scaled by price. The results are shown in Figures 9 and 10. The optimal smoothing
parameters used to estimate these contours are low, particularly the 0.10 used for the early
period, which compares to the value of 0.15 used in the earnings denominator specication.
Consistent with the low smoothing parameter, the contours for the early sample suggest a
high degree of nonlinearity, with a large portion of the vertical climb being concentrated
around the zero-surprise line. In contrast, the contours for the late-period are much more
evenly spaced, suggesting less nonlinearity.
While the evidence of nonlinearities seems clear, we nd no substantive evidence of any
benet from getting bad news out early. This is most obvious in the late-sample estimates.
In the early-sample estimates, this judgment requires more careful scrutiny. As shown in
gure 9, there appears to be no net benet from moving along the -.002 forecast-error locus,
for instance, from the zero revision to the zero surprise point. While moving further up the
locus (into negative revision and positive surprise territory) does appear to produce some
benet, the gain is small and statistically insignicant. Finally, we note that, as shown
in the appendix, the |EPS| scaling factor produces somewhat better ts to the data, at
least as judged using the Akaike Information Criterion (AIC) values for the |EPS|-scaled ts
compared to the ts scaled by price.
So far, the analysis ignores any potential role of heterogeneity, that is, the likelihood
that sensitivity to earnings news diers systematically across rms. This may be particu-
larly important if such dierences induce substantial variation in the propensity to play the
consensus-meeting game. For instance, Skinner and Sloan (1999) provide evidence suggesting
that stocks of high-growth rms are more vulnerable to negative earnings surprises, due to
their high valuations being so dependent upon investors optimistic expectations for earnings
growth. If so, these rms might be more prone to prerelease bad news than low-growth rms.
Moreover, investor awareness of such dierent propensities might inuence how the market
reacts to news. In particular, rms that habitually warn and then meet or beat expectations
23
or those that have not met expectations in recent quarters might face a dierent tradeo in
the current quarter than rms that recently reported negative surprises.
While it is unclear how such heterogeneity might bias our conclusions, we can examine
the robustness of our results by splitting the sample along some potentially important di-
mensions. This approach is used principally because computational and data constraints
limit our ability to expand the dimensionality of the estimation, although it does have the
advantage of allowing for very general qualitative comparisons. Two rm characteristics that
we consider are: (i) rm size, gauged by market value; and (ii) rm growth prospects, gauged
by the median of analysts long-term growth forecasts. Firm size may be an important factor
because, all else equal, larger rms tend to have more predictable earnings. Moreover, such
rms have a broader following in the investment community, and analysts may do a better
job of forecasting their earnings. Casual observation of press reports suggests that the very
largest rms devote a relatively high level of resources toward managing market expecta-
tions. As mentioned earlier, rm growth prospects have been shown to correlate with the
sensitivity of stock price to earnings news.
10
We perform a two-by-two sample split along the rm size and growth dimensions, produc-
ing four subsamples: large/high growth, large/low growth, small/high growth, and small/low
growth. The size split is based on beginning-of-quarter market value. A rm is assigned to
the large-rm subsample if its market value is above the median rms market value in
the same quarter. This produces a split that is balanced over time; the small-rm group
does not shrink over time due to the upward trend in nominal rm valuations. The growth
split is based on the sample median growth forecast. A rm is assigned to the high-growth
subsample if its analysts average long-term growth forecasts are above the sample median.
Figure 11 displays tted surfaces for the four subsamples based on their optimal smooth-
ing parameters. Noting that the vertical axes dier markedly across the subsamples, the
10
We have explored whether the number of analysts following a rm aects our results. Specically, we
imposed a lower limit on the number of analysts tracking a rm in order for the rm to be included in the
sample, and re-ran all of our calculations. Our results were not aected in a material way by this type of
restriction.
24
estimated surfaces for high growth rms (the two bottom gures) are much steeper than
those for the set of low-growth rms (the two top gures). This indicates that earnings
news can explain more stock return variance for high-growth rms than for low-growth
rms. Moreover, since the horizontal axes for the high- and low-growth results cover similar
ranges, the steeper slope also implies that a given magnitude of earnings news tends to have a
larger impact on high-growth rms stock prices. In contrast, comparing the small and large
samples while holding the growth class constant, it appears that smaller rms experience a
wider range of earnings news; in particular, they experience more extreme negative surprises
and revisions than large rms.
The associated contours are shown in gure 12. The top row of gures again displays
the contours for the low-growth rms, small and large. As in the overall sample, bringing
out bad news early does not appear to produce any net benet for those rms, and in many
instances appears to be counter-productive. However, this nding is a bit more nuanced for
at least one of the subsamples. Consider the large low-growth rm contours. Moving along
the negative -0.10 (negative 10 percent) forecast error locus, from zero revision (0, -0.10) to
zero surprise (-0.10, 0) appears to reduce stock returns on average by 2 percent. However,
the concave-shaped contours imply that this is the worst place to be. Moving up from (-0.10,
0) to (-0.25, 0.15) appears to boost return 2 percent, which suggests that it may be better
to exaggerate the possible shortfall than to warn and then just meet revised expectations,
at least in this case.
The results for the other three subsamples suggest that the trade-o from preannouncing
news is at best neutral over the vast majority of the surprise/revision space. This result
comes through quite clearly in the case of large high-growth rms. This is the group of rms
that is probably most prone to playing the consensus-meeting game, and, as evidenced by
their more tightly-packed contours, their stock prices are much more sensitive to earnings
news compared to their low-growth counterparts discussed above. The most interesting
group, however, may be the small high-growth rms. For these rms, the gure shows
25
about 35 contour lines (35 percentage points of return variation), which implies that earnings
forecast errors explain a large range of abnormal returns. The contours also reveal substantial
nonlinearity; the tightly packed lines in the region just to the southwest of (0,0) indicate
that relatively small negative revisions as well as small negative surprises have particularly
strong, albeit symmetric, eects on stock returns.
We end our search for the timing eect by conditioning our sample split on rms recent
surprise histories. In one group, we include only rms that did not have a negative surprise
in either of the two preceding quarters; the second group contains all other rms, that is,
rms with one or two negative surprises in the previous two quarters. As shown in panels
A and B of gure 13, this sample split again conrms the robustness of our earlier results.
The scale ranges on the surprise axis of the contours do indicate that rms with a recent
negative surprise are more prone to issue a negative surprise again. However, we nd that
neither group of rms appears to benet by preannouncing negative news in order to meet
expectations at the time of report.
5 Conclusion
In this paper, we examined the stock price benet of meeting or beating earnings expec-
tations. We estimated the eect of quarterly earnings news on quarterly stock returns by
splitting analysts total forecast errors into a forecast revision and an earnings surprise. We
then estimated the eects of these forecast revisions and earnings surprises on the cumulative
abnormal return over the period.
The most important methodological dierence between our study and previous studies
is our use of loess, a nonparametric estimation technique that allows for a wide range of
functions that map earnings news into abnormal returns. A second important methodological
consideration in our analysis is the econometricians choice of the preannouncement period.
We conjecture that revisions early in the quarter might be contaminated by the previous
26
quarters news, which could create a spurious asymmetry in the magnitude of stock price
responses to forecast revisions and earnings surprises. Finally, we examined the choice of
the scaling factor applied to the forecast revisions and surprises.
In contrast to previous studies, we did not nd persuasive evidence of a short-term stock
price benet to preannouncing bad news; that is to say, we found little or no dierence
in the sensitivity of stock returns to early forecast revisions and earnings surprises. Our
nonparametric approach does uncover signicant and fairly interesting nonlinearities. In
particular, we nd that the sensitivity of returns to earnings news tends to get stronger
when the news is close to zero. Moreover, this would appear to be true regardless of whether
the news is reected in revisions or surprises.
There is one notable case where we do nd evidence consistent with the hypothesis
that rms benet by getting bad news out early. When we estimate the response function
using the longer revision period, on the 1987-1995 subsample, surprises appear to have a
larger eect on returns than revisions over an important part of the sample space. However,
when the model is estimated using a shorter (6-week) revision period, when more of the
revisions are presumably driven by preannouncements, the asymmetric response disappears.
Moreover, when we estimate the response function on the post-1995 sample, this result is
again reversed, regardless of the denition employed for the revision period.
An appealing interpretation that reconciles these results is that, in earlier years, equity
analysts may not have been particularly diligent about reworking their quarterly earnings
forecasts following previous-quarter announcements. If so, then revisions over the earlier
part of the quarter would have partly reected information that may have already been
incorporated into stock prices. However, as quarterly earnings forecasts garnered increasing
attention during the 1990s, analysts may have become more assiduous about updating their
current-quarter estimates.
We further examined the issue by splitting the sample into subgroups by size and earn-
ings prospects. Again, we found little evidence of an asymmetric stock return response to
27
the timing of news. However, for large, low-growth rms, it does appear to be better to
exaggerate any possible earnings shortfalls than to warn and just meet expectations. Fi-
nally, we conditioned on rms recent surprise histories to see if rms with a track record of
negative surprises, or a track record of meeting expectations, might face asymmetric stock
return responses. Again we found no evidence of an asymmetric response.
The absence of any short-term stock price benet from getting bad news out early begs the
question: Why do rms manage their news releases? A denitive answer is beyond the scope
of this paper, but a few comments are in order. First, it is possible that individual managers
might believe that such actions will produce a near-term benet to their stock price even if,
on average, this is not the case. Indeed, if researchers in possession of the comprehensive
data can not agree on the stock price benets, should we expect managers, focused largely
on their own rms experience, to know the average eect? Second, the absence of any clear
short-term benet does not rule out the possibility of a longer-term reputational benet. As
pointed out earlier, both Chevis et al. (2002) and Liu and Yao (2003) provide evidence to
suggest that rms that habitually meet expectations tend to be more highly valued, that
is, have a higher stock price level given fundamentals. A comparison of short run returns
probably has little power as a test of such longer-term valuation benets.
In closing, it is worth reemphasizing that a variety of rationales that do not presuppose
any benet to quarterly stock returns have been proposed to explain this behavior. In fact,
the hypothesis of Aboody and Kasznik (2000), that management is motivated to warn by the
desire to receive stock option grants when their stock price is relatively low, is perhaps even
more plausible in light of our ndings. Furthermore, managers that intend to sell shares after
the end of a quiet period might also benet directly by shifting the timing of bad news
and the associated volatility along the lines suggested by Richardson et al. (2003). Finally,
the traditional rationale for the early release of bad news that management is striving to
mitigate the risk of securities litigation does not presuppose any short-term stock price
benet.
28
Table 1: Univariate Statistics
The table displays univariate statistics for revisions, surprises, and abnormal returns. The table displays the
25
th
, 50
th
, and 75
th
percentiles for the variables, plus the interquartile ranges (labeled 75 25), with all
values multiplied by 100.
Panel A: |EPS| scaling factor
1987-1995 1996-2001
Abnormal Abnormal
Percentile return Revision Surprise return Revision Surprise
12-week revision, N=22,987 N=42,424
25 -7.90 -5.15 -5.86 -13.0 -3.37 -1.19
50 -0.18 -0.27 1.08 -0.90 0.00 2.34
75 7.43 1.67 7.14 10.17 0.50 8.33
75-25 15.33 6.82 13.00 23.21 3.87 9.52
25 -8.17 -1.71 -8.64 -13.00 -1.14 -1.40
50 -0.31 0.00 0.54 -1.05 0.00 2.36
75 7.39 0.12 7.69 10.04 0.00 8.61
75-25 15.56 1.83 16.33 23.08 1.14 10.01
Panel B: Price scaling factor
1987-1995 1996-2001
Abnormal Abnormal
Percentile return Revision Surprise return Revision Surprise
25 -8.35 -0.10 -0.12 -13.9 -0.06 -0.02
50 -0.49 -0.01 0.01 -1.24 0.00 0.03
75 7.38 0.03 0.12 10.15 0.01 0.12
75-25 15.73 0.12 0.23 24.00 0.06 0.14
25 -8.77 -0.03 -0.18 -14.0 -0.02 -0.03
50 -0.67 0.00 0.00 -1.43 0.00 0.03
75 7.24 0.00 0.13 9.99 0.00 0.12
75-25 16.01 0.03 0.31 23.95 0.02 0.15
29
Table 2: Regressions of Abnormal Returns on Scaled Revisions and Surprises
The table displays linear regression results for four variations of the basic specication
Abnormal return =
0
+
1
(12-week revision) +
2
(6-week revision) +
3
(Surprise) +,
with the revisions and surprises as dened in the main text. The regression is repeated for each scale factor
over each sample period. The early subsample covers the period 1987-1995, while the late subsample covers
the period 1996-2001. The sampling frequency is quarterly. The t-values displayed beneath each estimate
are based on heteroscedasticity-robust standard errors. The sample sizes are smaller than those displayed
in table 1 owing to the inclusion of both revision variables; observations missing either variable are dropped
from the regression.
Normalization Period
0

1

2

3
N R
2
|EPS| Early 0.00 0.05 0.23 0.16 19,259 0.060
3.48 4.12 11.79 25.22
Late -0.02 0.21 0.14 0.28 35,825 0.048
-16.94 12.42 5.99 26.49
Price Early 0.00 2.91 14.43 9.34 20,971 0.062
0.12 4.94 13.25 26.87
Late -0.02 14.17 9.80 17.83 39,605 0.051
-19.37 13.91 6.92 28.60
30
Table 3: Width of 95 Percent Condence Intervals across Solution Surface
The table displays the widths of 95 percent condence intervals at the indicated points on the solution
surface. For example, in panel A, when the 12-week revision is -0.05 (-5 percent) and the surprise is -0.05,
the width of the 95 percent condence interval around the tted value is 0.024 (2.4 percentage points wide).
The width of the condence intervals across the solution space indicates the degree to which the contours
shown on the relevant contour plot can be dierentiated. The condence intervals are for the late sample
period (1996-2001) using the |EPS| scaling factor; the widths of the condence intervals for our other ts
are similar in magnitude.
Panel A: 12-week revision
Revision
Surprise -0.05 0.00 0.05
0.05 0.024 0.014 0.027
0.00 0.021 0.013 0.034
-0.05 0.024 0.020 0.037
Panel B: 6-week revision
Revision
Surprise -0.05 0.00 0.05
0.05 0.030 0.014 0.037
0.00 0.026 0.012 0.048
-0.05 0.027 0.017 0.052
31
Figure 1: Decomposition of Total Forecast Error into Revision and Surprise
-
Beginning of
quarter
t
Previous quarter
EPS report
t
7 days
F
0
t
F
1
t
End of
quarter
t
F
2
t
Current quarter
EPS report
t
. .
6-week
revision
..
12-week revision
..
Surprise
..
TFE
3
2
Figure 2: Scatterplots of 12-Week Revisions and Surprises
Panel A of the gure displays a scatterplot of revisions against surprises for the early period (1987-1995).
The data are scaled by |EPS| and reect our other data lters discussed in the main text. Panel B displays
a scatter of revisions against surprises for the late period (1996-2001). The boxes in panels A and B show
the regions plotted in gures 3 and 4, respectively.
Panel A: Early Period (1987-1995)
-1
-0.8
-0.6
-0.4
-0.2
0
0.2
-0.8 -0.6 -0.4 -0.2 0 0.2
S
u
r
p
r
i
s
e
Revision
Displayed surface
Panel B: Late Period (1996-2001)
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
0.4
-1 -0.8 -0.6 -0.4 -0.2 0 0.2
S
u
r
p
r
i
s
e
Revision
Displayed surface
33
Figure 3: Fitted Surfaces for 1987-1995 Period, |EPS| Scaling Factor
The gure displays tted surfaces for the early period subsample using the |EPS| scaling factor and the 12
week revision. The tting method is locally weighted least squares, with each surface depicting the t at the
indicated smoothing parameter. The sample size is 22,987.
Smoothing parameter = 0.15
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
Revision
-0.6
-0.4
-0.2
0
0.2
Surprise
-0.1
-0.08
-0.06
-0.04
-0.02
0
0.02
0.04
0.06
Excess return
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
Revision
-0.6
-0.4
-0.2
0
0.2
Surprise
-0.1
-0.08
-0.06
-0.04
-0.02
0
0.02
0.04
0.06
Excess return
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
Revision
-0.6
-0.4
-0.2
0
0.2
Surprise
-0.1
-0.08
-0.06
-0.04
-0.02
0
0.02
0.04
0.06
Excess return
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
Revision
-0.6
-0.4
-0.2
0
0.2
Surprise
-0.1
-0.08
-0.06
-0.04
-0.02
0
0.02
0.04
0.06
0.08
Excess return
34
Figure 4: Fitted Surfaces for 1996-2001 Period, |EPS| Scaling Factor
The gure displays tted surfaces for the late period subsample using the |EPS| scaling factor and the 12
week revision. The tting method is locally weighted least squares, with each surface depicting the t at the
indicated smoothing parameter. The sample size is 42,424.
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
Revision
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
Surprise
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
Excess return
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
Revision
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
Surprise
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
Excess return
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
Revision
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
Surprise
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
Excess return
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
Revision
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
Surprise
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
Excess return
35
Figure 5: Iso-Return Contours for 1987-1995 Period, |EPS| Scaling Factor
The gure displays iso-return contours and three information policy lines. The t is based on early-period
data and the |EPS| scaling factor, and the revision is measured over a 12 week interval. The sample size is
22,987 rm-quarter observations and the optimal smoothing parameter is 0.15615, determined by generalized
cross-validation. The iso-return contours are spaced at one percentage point intervals; moving from a point
on one contour to a point on an adjacent contour represents a one percentage point change in abnormal
return. The information policy lines are for total forecast errors (TFE) of 0, -5, and -10 percent. Movement
along an information policy line represents an information release policy by the rm in terms of the timing
of information release. Points to the northwest on a policy line represent a policy of releasing bad news in
the revision period and good news in the surprise period.
-0.60
-0.40
-0.20
0.00
0.20
-0.50 -0.40 -0.30 -0.20 -0.10 0.00 0.10
S
u
r
p
r
i
s
e
Revision
Contours
TFE = 0.00
TFE = -0.05
TFE = -0.10
36
Figure 6: Iso-Return Contours for 1996-2001 Period, |EPS| Scaling Factor
The gure displays iso-return contours and three information policy lines. The t is based on late-period
-0.30
-0.20
-0.10
0.00
0.10
0.20
0.30
-0.60 -0.50 -0.40 -0.30 -0.20 -0.10 0.00 0.10
S
u
r
p
r
i
s
e
Revision
Contours
TFE = 0.00
TFE = -0.05
TFE = -0.10
37
Figure 7: Iso-Return Contours for 1987-1995 Period, 6-Week Revision, |EPS| Scaling Factor
-0.80
-0.60
-0.40
-0.20
0.00
0.20
-0.30 -0.25 -0.20 -0.15 -0.10 -0.05 0.00 0.05
S
u
r
p
r
i
s
e
Revision
Contours
TFE = 0.00
TFE = -0.05
TFE = -0.10
38
Figure 8: Iso-Return Contours for 1996-2001 Period, 6-Week Revision, |EPS| Scaling Factor
-0.40
-0.30
-0.20
-0.10
0.00
0.10
0.20
0.30
-0.40 -0.30 -0.20 -0.10 0.00
S
u
r
p
r
i
s
e
Revision
Contours
TFE = 0.00
TFE = -0.05
TFE = -0.10
39
Figure 9: Iso-Return Contours for 1987-1995 Period, 6-Week Revision, Price Scaling Factor
data and the price scaling factor, and the revision is measured over a 6 week interval. The sample size is
-0.015
-0.010
-0.005
0.000
0.005
-0.005 -0.004 -0.003 -0.002 -0.001 0.000 0.001
S
u
r
p
r
i
s
e
Revision
Contours
TFE = 0.000
TFE = -0.001
TFE = -0.002
40
Figure 10: Iso-Return Contours for 1996-2001 Period, 6-Week Revision, Price Scaling Factor
The gure displays iso-return contours and three information policy lines. The t is based on late-period
-0.006
-0.004
-0.002
0.000
0.002
0.004
0.006
-0.006 -0.005 -0.004 -0.003 -0.002 -0.001 0.000 0.001
S
u
r
p
r
i
s
e
Revision
Contours
TFE = 0.000
TFE = -0.001
TFE = -0.002
41
Figure 11: Fitted Surfaces for 1996-2001 Period, 6-Week Revision, Large and Small, High-
and Low-Growth Firms, |EPS| Scaling Factor
The gure displays tted surfaces for rms split into subsamples based on size and growth prospects, where
size is measured by market value and growth prospects by analysts long-term growth forecasts. A rm is
classied as large if its market value is above the median rm market value for the given quarter. A rm
is classied as high-growth if its consensus long-term growth forecast is above the sample median consensus
long-term growth forecast. The upper two panels display the surfaces for small and large low-growth rms,
respectively. The lower two panels display the surfaces for small and large high-growth rms, respectively.
The samples sizes and smoothing parameters used for each t are shown in the appendix.
Small, Low-Growth Firms
-0.60
-0.50
-0.40
-0.30
-0.20
-0.10
0.00
0.10
Revision
-0.80
-0.60
-0.40
-0.20
0.00
0.20
0.40
Surprise
-0.20
-0.10
0.00
0.10
Excess return
Large, Low-Growth Firms
-0.40
-0.30
-0.20
-0.10
0.00
0.10
Revision
-0.30
-0.20
-0.10
0.00
0.10
0.20
0.30
Surprise
-0.10
-0.05
0.00
0.05
0.10
Excess return
Small, High-Growth Firms
-0.80
-0.60
-0.40
-0.20
0.00
0.20
Revision
-0.60
-0.40
-0.20
0.00
0.20
0.40
Surprise
-0.40
-0.30
-0.20
-0.10
0.00
0.10
Excess return
Large, High-Growth Firms
-0.30
-0.20
-0.10
0.00
0.10
Revision
-0.20
-0.10
0.00
0.10
0.20
0.30
Surprise
-0.20
-0.10
0.00
0.10
0.20
Excess return
42
Figure 12: Iso-Return Contours for 1996-2001 Period, 6-Week Revision, Large and Small,
High- and Low-Growth Firms, |EPS| Scaling Factor
The gure displays the iso-return contours for the four surfaces shown in gure 11 above. The upper two
panels display the contours for small and large low-growth rms, respectively. The lower two panels display
the contours for small and large high-growth rms, respectively. Note that the vertical and horizontal axes
all vary. The samples sizes and smoothing parameters used for each t are shown in the appendix. The
iso-return contours are spaced at one percentage point intervals; moving from a point on one contour to a
point on an adjacent contour represents a one percentage point change in abnormal return. The information
policy lines are for total forecast errors (TFE) of 0, -5, and -10 percent. Movement along an information
policy line represents an information release policy by the rm in terms of the timing of information release.
Points to the northwest on a policy line represent a policy of releasing bad news in the revision period and
good news in the surprise period.
-0.60
-0.40
-0.20
0.00
0.20
-0.50 -0.40 -0.30 -0.20 -0.10 0.00
S
u
r
p
r
i
s
e
Small, Low-Growth Firms
Contours
TFE = 0.00
TFE = -0.05
TFE = -0.10
-0.20
-0.15
-0.10
-0.05
0.00
0.05
0.10
0.15
0.20
-0.35 -0.30 -0.25 -0.20 -0.15 -0.10 -0.05 0.00 0.05
Large, Low-Growth Firms
Contours
TFE = 0.00
TFE = -0.05
TFE = -0.10
-0.50
-0.40
-0.30
-0.20
-0.10
0.00
0.10
0.20
0.30
-0.60 -0.50 -0.40 -0.30 -0.20 -0.10 0.00
S
u
r
p
r
i
s
e
Revision
Small, High-Growth Firms
Contours
TFE = 0.00
TFE = -0.05
TFE = -0.10
-0.15
-0.10
-0.05
0.00
0.05
0.10
0.15
0.20
0.25
-0.25 -0.20 -0.15 -0.10 -0.05 0.00 0.05
Revision
Large, High-Growth Firms
Contours
TFE = 0.00
TFE = -0.05
TFE = -0.10
43
Figure 13: Iso-Return Contours for 1996-2001 Period, 6-Week Revision, Sample Split on
Lagged Surprises, |EPS| Scaling Factor
The gure displays the iso-return contours for ts based on late-period data and the |EPS| scaling factor.
The revision is measured over the six week interval. Panel A displays the t for the subsample of rms with
at least 1 lagged negative surprise; Panel B shows the t for the subsample of all other rms. The sample
sizes and smoothing parameters used for each t are shown in the appendix. The iso-return contours are
spaced at one percentage point intervals; moving from a point on one contour to a point on an adjacent
contour represents a one percentage point change in abnormal return. The information policy lines are for
total forecast errors (TFE) of 0, -5, and -10 percent. Movement along an information policy line represents an
information release policy by the rm in terms of the timing of information release. Points to the northwest
on a policy line represent a policy of releasing bad news in the revision period and good news in the surprise
period.
Panel A: Firms with at least 1 lagged negative surprise
-0.50
-0.40
-0.30
-0.20
-0.10
0.00
0.10
0.20
0.30
-0.60 -0.50 -0.40 -0.30 -0.20 -0.10 0.00
S
u
r
p
r
i
s
e
Revision
Contours
TFE = 0.00
TFE = -0.05
TFE = -0.10
Panel B: All other rms
-0.15
-0.10
-0.05
0.00
0.05
0.10
0.15
0.20
0.25
-0.30 -0.25 -0.20 -0.15 -0.10 -0.05 0.00 0.05
S
u
r
p
r
i
s
e
Revision
Contours
TFE = 0.00
TFE = -0.05
TFE = -0.10
44
A Smoothing Parameter Selection
Following Cleveland and Devlin (1988), the expected mean squared error of the loess esti-
mator, given by
M
h
=
_
E
N
i=1
_

f
h
(x
i
) f(x
i
)
_
2
_
2
, (5)
can be decomposed into a term representing the contribution of bias, B
h
, and the contribution
of variance, V
h
, to the overall mean squared error. Here we have subscripted M and

f by h,
to emphasize that the calculations are conditional on the degree of smoothing. A larger h
is analogous to a wider bandwidth in kernel regression, implying a lower variance estimate
at the risk of potentially greater bias.
11
Denoting the residual sum of squares by RSS
h
, the
estimated error variance by
2
, and by L
h
the matrix such that y
h
= L
h
y, it can be shown
that:
12
M
h
= B
h
+V
h
, where (6)
B
h
=
RSS
h

2
tr [(I L
h
)(I L
h
)
] , and (7)
V
h
= tr [L
h
L
h
] , (8)
where I is the identity matrix. As shown in Cleveland and Devlin (1988) it is straightforward
to compute an estimate

M
h
of M
h
. Moreover, it is possible (albeit highly computationally
intensive) to compute approximations to the distribution of

M
h
under the null hypothesis of
zero bias.
The M-plot is a graph of

M
h
against V
h
for a range of values of h. The basic idea is to
consider a range of smoothing parameters running from the standard OLS t (including all
11
The term V
h
is often referred to as the equivalent number of parameters. This is an intuitive label
because, under ordinary least squares, V
h
is equal to the trace of the projection matrix, which in turn is
equal to the number of parameters being estimated. While the loess operator is not a projection matrix, it is
nevertheless the case that V
h
increases as h decreases less smoothing results in a higher equivalent number
of parameters, and vice-versa.
12
An estimate of
2
is obtained from the residuals of a t with very small h a highly localized t.
45
of the data in each local regression) to very localized ts in order to see how the contribution
of bias changes as the degree of smoothing is varied. Figure A1 presents a representative set
of estimates of M-statistics at dierent degrees of smoothing and their associated condence
intervals under the null hypothesis of zero bias for the late period |EPS|-scaled dataset using
the 12-week revision.
13
The points on the plot show the estimated M-statistic values. The
45-degree line through the origin and the rightmost M-statistic value show the values of the
M-statistics that are expected under the null hypothesis. The vertical lines show the 95
percent condence bands, while the x symbols on the vertical lines indicate the 90 percent
condence bands. The leftmost point - at an equivalent number of parameters equal to 3
- gives the M-statistic at the OLS t. It is clear from the plot that the OLS t is heavily
biased - the null hypothesis of zero bias is soundly rejected. As the equivalent number of
parameters rises, the estimated M-statistics fall. For an equivalent number of parameters
equal between nine and twelve, we cannot reject the null hypothesis of zero bias. As we
increase the number of parameters from twelve, the bias again rises, suggesting that the
optimal smoothing parameter is the one that uses approximately 60 percent of the data.
It should also be noted that this t is the one that is selected with the generalized cross-
validation procedure for these data.
In order to conserve space, we do not display all of the M-plots for our various subsamples.
Table A1 displays the smoothing parameters selected by the generalized cross-validation
technique. In general, our M-plot analyses conrmed these settings.
13
These calculations were made on a random sample of 2,500 points from the overall dataset. The calcu-
lation of the M-statistics on the full dataset is computationally infeasible.
46
Figure A1: M-Plot, 12-Week Revision, |EPS| Scaling Factor
-10
0
10
20
30
40
50
0 5 10 15 20 25 30 35 40 45 50
M
-
S
t
a
t
i
s
t
i
c
Equivalent Number of Parameters
Late Period Sample, N=2,500
M-Statistic
95% Confidence Interval
90% Confidence Interval
47
Table A1: Generalized Cross-Validation Results
The table displays the sample size (N), the generalized cross-validation objective function value (GCV), the
Akaike Information Criterion (AIC), and the optimal smoothing parameter for all of the estimates discussed
in the main text. Panel A displays the main sample splits on sample period, scaling factor, and revision
denition. Panel B displays the sample splits on rm growth and size, and Panel C displays the split on
recent earnings news.
Panel A: Sample Period, Scaling Factor, and Revision Sample Splits
Sample Scaling Smoothing
period factor N Revision GCV AIC parameter
All rms
Early |EPS| 22,987 F
0
F
2
6.248e-07 -3.24309 0.15615
49,041 F
1
F
2
3.063e-07 -3.19828 0.15619
Price 54,005 F
1
F
2
2.978e-07 -3.12987 0.10670
Late |EPS| 42,424 F
0
F
2
9.043e-07 -2.26050 0.62499
51,396 F
1
F
2
7.418e-07 -2.26679 0.15623
Price 57,106 F
1
F
2
7.172e-07 -2.19526 0.15628
Panel B: Late Period, |EPS| Scaling Factor, F
1
F
2
Revision, Growth and Size Sample
Splits
Growth Size Smoothing
Class Class N GCV AIC Parameter
Low Small 15,918 2.18e-06 -2.36219 0.22355
Low Large 14,968 1.08e-06 -3.12539 0.31217
High Small 10,460 7.34e-06 -1.56637 0.15626
High Large 10,079 4.81e-06 -2.02729 0.62452
Panel C: Late Period, |EPS| Scaling Factor, F
1
F
2
Revision, Previous Earnings Surprise
Sample Split
Smoothing
Surprise History N GCV AIC Parameter
No recent negative surprises 16,709 5.464e-07 -3.34235 0.15627
A negative surprise in previous 2 quarters 15,638 1.040e-07 -3.38635 0.61745
48
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50

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