Accounting Research Center, Booth School of Business, University of Chicago

Accounting Research Center, Booth School of Business, University of Chicago
Corporate Forecasts of Earnings Per Share and Stock Price Behavior: Empirical Test
Author(s): James M. Patell
Source: Journal of Accounting Research, Vol. 14, No. 2 (Autumn, 1976), pp. 246-276
Published by: Wiley on behalf of Accounting Research Center, Booth School of Business, University
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Corporate Forecasts of Earnings per Share
and Stock Price Behavior: Empirical Tests
JAMES M. PATELL*
1. Introduction
The disclosure of corporate forecasts of projected annual earnings was
a topic of intensive debate within the investment community during the
years 1970-75. Questions of accuracy, objectivity, independent certifica-
tion, and investment utility were examined from a number of theoretic
and pragmatic viewpoints.' Most of these inquiries appear to assume that
an investor's beliefs and/or actions may be affected by the disclosure of a
management forecast, and several explore the possible rewards and sanc-
tions that a firm may experience as a result of forecast accuracy. The
purpose of this study is to test the hypothesized information content of
management forecasts through the examination of the common stock
price behavior which accompanied the voluntary disclosure of 336 fore-
casts of annual earnings per share during the years 1963-67. The results
reported here indicate that these forecast disclosures were accompanied
by significant price adjustments, from which the inference may be drawn
that either the data presented in a management forecast, the act of volun-
tary disclosure, or both, convey information to investors.
*
Assistant Professor, Stanford University. I gratefully acknowledge the guidance
and assistance of Professors Robert S. Kaplan, Yuji Ijiri, and Marcus C. Bogue ILL.
The constructive comments of Professors George Foster, Nicholas Gonedes, Melvin
Greenball, and Robert May, and the financial support of the Arthur Andersen &
Co. Foundation are appreciated also.
I
See Daily [19711,
Copeland and Marioni [19721, Gray, Gillis, and Stewart [1973],
McDonald [1973], Brandon and Jarrett [19741, and Prakash and Rappaport [19741.
246
CORPORATE FORECASTS OF STOCK PRICE BEHAVIOR 247
In its Statement of February 2, 1973,2 the Securities and Exchange Com-
mission indicated its intention to develop a framework for orderly dis-
closure of voluntary forecasts:
The Commission recognizes that projections are currently widespread in the
securities markets and are relied upon in the investment process. Persons in-
vest with the future in mind and the market value of a security reflects the
judgments of investors about the future economic performance of the issuer.
Thus, projections are sought by all investors, whether institutional or indi-
vidual. The Commission is concerned, however, that all investors do not have
equal access to this material information.
The Commission also noted that the preparation and disclosure of an
earnings forecast is not without cost to the issuer, and that the lack of
generally accepted principles for preparing forecasts precludes an inde-
pendent verification process. Nevertheless, the assumption that forecasts
are potentially informative for investors is inherent in the Commission's
statement.
The 1973 SEC statement was directed at ensuring uniform access
by
all investors to voluntarily released forecasts, which is distinct from the
issue of mandatory forecast disclosure by all firms. By demonstrating the
stock price behavior which accompanied uniform public disclosure (ap-
proximated by publication in the Wall Street Journal), this study illustrates
price changes which could have been anticipated by an individual possessing
private foreknowledge of the content and timing of the forecast.3 However,
since I deal only with voluntary disclosure, the question of investor and
firm response to mandated forecasting procedures remains unresolved.
The possibility that earnings forecasts possess information content arises
in
several theoretical contexts. In their development of a theory
of
in-
vestment, Miller and Modigliani [1958] state both the relation between
earnings and the value of the firm, and the necessity of considering the
capitalized value of the "stream of profits over time." The capital asset
2
"Disclosure of Projections of Future Economic Performance," Release No.
33-5362 and No. 34-9984, February 2, 1973. In the subsequent Release No. 33-5581
and No. 34-11374 of April 28, 1975, the Commission reaffirmed the views expressed in
the 1973 statement and proposed specific rule changes to implement forecast dis-
closure. In addition to defining projections, detailing the circumstances which re-
quire their filing, and stipulating the method of filing, the proposed rules also de-
fined "safe harbor" conditions under which a forecast would not be deemed to be an
untrue or misleading statement of material fact. After considering public comments,
the Commission formally withdrew these proposals (Release No. 33-5699 and No.
34-12371, April 23, 1976) and much less detailed guides for making and filing forecasts
were proposed. The Commission did, however, retain the view that ". . . investors
appear to want management's assessment of a company's future performance.
("General Views of the Commission," Release No. 33-5699).
3 See Gonedes, Dopuch and Penman [1976] for a discussion of the information-
production situations which may lead to the existence of such an individual, and
the possible economic consequences.
248 JOURNAL OF ACCOUNTING RESEARCH, AUTUMN 1976
pricing model of Sharpe [1964] and Lintner [1965] is integrated with the
Miller-iMiodigliani valuation model by Hamada [1969], who proves that,
under certain restrictive assumptions, the value of a firm depends only
on the probability distribution of the firm's future earnings (considered
jointly with other firms) and market factors which set the risk-return
payoff structure. Within this formulation, the information content of an
earnings forecast would lie in its effect on the parameters of the assessed
probability distribution of future earnings in relation to the other assets
in the investment opportunity set.
In examining the price changes associated with forecast disclosure, one
finds the inference that price adjustments are the effects of new informa-
tion is essentially a restatement of the semistrong form of the efficient
market hypothesis (Fama [1970]). This model of stock price behavior
asserts that the current stock price fully reflects all public knowledge con-
cerning the firm, and that the price adjusts efficiently to the public dis-
closure of new information. The extent to which an earnings forecast
alters investors' beliefs may be a function of (at least) three attributes:
the imputed accuracy of the estimate, its newness (prior public non-
availability of the forecast's
content),
and the imputed motivation for the
act of voluntary disclosure, as distinguished from content. Although the
accuracy of a forecast can be determined in an ex post fashion when the
annual earnings per share are eventually announced, the realized earnings
numbers were not used in the tests performed here. The tests in section 7
do make use of information available prior to the forecast disclosure date,
and the test results allow interpretation of differential responses to act
and content.
The measurement procedures used here rely heavily on the study of
annual earnings announcements by Beaver [1968] and the study of quart-
erly earnings announcements by May [1971]. The market expectation
models of annual and quarterly earnings employed by Green and Segall
[1966, 1967], Ball and Brown [1968], Brown and Niederhoffer [1968], and
Brown and Kennelly [1972] are incorporated here, and these papers pro-
vide useful references for gauging the relative magnitude of effects. Green
and Segall also briefly examine the accuracy of a small sample of voluntary
corporate forecasts, and Copeland and Marioni [1972] enlarge the sample
somewhat in comparing executive and "naive" forecasts. Foster [1973]
demonstrates price adjustments which accompanied preliminary estimates
of earnings per share, made after the end of the fiscal year by corporate
executives.
The recent paper by Gonedes, Dopuch, and Penman [1976] addresses the
topic of forecast disclosure rules from both theoretical and empirical view-
points. Using a sample of analysts' forecasts and statistical techniques
different from those used here, they reject the null hypothesis that these
forecasts conveyed no information pertinent to valuing firms. Further,
they indicate that the magnitude of the price revision effects are largest
for that portion of their sample possessing the smallest ratio of analyst fore-
casted earnings per share to share price. The tests conducted in section 7
of this study adopt a different method for classifying management fore-
casts as either optimistic or pessimistic. Cheever [1975] has also examined
a sample of forty-six management forecasts for 1972, using tests very
similar to two of the three tests reported in this study.
Section 2 of this paper details the characteristics of the forecast data.
Sections 3 and 4 develop the test procedures, and sections 5 and 6 present
the empirical findings for the sample as a whole and for selected subsamples.
A comparison to the price activity which accompanied the eventual year-
end announcement of annual earnings is also presented in section 6. Section
7 uses prior years' earnings data to construct alternative estimates of fu-
ture earnings and classifies management forecasts as optimistic or pessi-
mistic in relation to these alternative predictions. Section 8 briefly sum-
marizes the results.
2. Sample Design
In order to resolve questions of authenticity and reliability, the following
operational definition of an earnings forecast was employed. A firm is
considered to have publicly disclosed an earnings forecast when a com-
pany official is quoted in the Wall Street Journal as predicting either a
point-estimate of annual earnings per share or an estimate of the minimum
or maximum expected earnings per share. The date of forecast disclosure
is set as the date of publication in the Wall Street Journal.
The total sample consists of 336 earnings forecasts released by 258
firms during the years 1963-68. The number of forecasts by a particular
firm varies from one to four. Microfilm daily copies of the Wall Street
Journal were examined for the years noted and yielded an initial sample of
approximately 430 forecasts. Application of the eight selection criteria
listed below reduced the sample to its final total of 336.
(1) The firm must be traded on the New York Stock Exchange. (2) No
dividend announcement was made during the week of the forecast
release. (3) No stock split announcement was made during the seventeen-
week period centered on the week of the forecast release. (4) No forecast is
included which occurred later than the end of the third fiscal quarter.
(5) The forecast must be directly attributed to a company official. (6)
The earnings forecast must be of sufficient quantitative precision (in
terms of dollar amounts or percents) to allow a point estimate of the ex-
pected earnings or the maximum or minimum expected earnings. (7)
The article containing the forecast must contain no additional new dis-
closure of financial accounting information other than first- or second-
quarter earnings or sales. (8) The forecast must be the first forecast of
annual results released by the firm during the fiscal year.
Criterion (1) limited the sample to firms for which weekly price and
250 JAMES M. PATELL
dividend data could be readily constructed from available daily
data.4
Criteria (2) and (3) were selected to prevent misrepresentation
of
price
adjustments which may accompany other significant financial events.
One forecast was also excluded due to the occurrence of a tender offer for
the firm's stock during the forecast period.
Criterion (4) was included as an attempt to separate forecasts of
pro-
jected
year-end results from advance releases of essentially complete
year-end results. Foster [1973] demonstrated that such preliminary
an-
nouncements can be associated with stock price changes. For this reason,
no forecasts were collected for the months September through December.
Furthermore, the fiscal year end of each firm was determined in order to
exclude fourth-quarter releases for non-December 31 fiscal year
firms.
Criterion (5) excluded capsule forecasts printed without source: broker
or investment analyst forecasts, market analyses, and industry surveys.
All forecasts were taken from a feature article on the particular firm and
were usually attributed by name to the chief operating officer. Criterion
(6) was selected to limit the sample to relatively "hard" forecasts. Fore-
casts are included only if they furnish: (a) a point estimate of the pro-
jected
earnings per share; or (b) a point percent growth (or decline)
from
the previous year earnings per share; or (c) a projected equality with the
previous (or some other stated) year earnings per share; or (d) a minimum
(or maximum) point estimate of earnings per share. Two hundred and
four of the 336 forecasts satisfied conditions (a), (b), or (c), and this sub-
sample will later be referred to as the "point" subsample. The remaining
132 forecasts were usually worded, "Earnings per share will be at least
$x.xx," and a few were worded, "Earnings per share will be less than
$x.xx." This second subsample is referred to as the "level" subsample.
The price adjustments of these two subsamples are presented separately
(although they do not appear markedly different) in the empirical
results
which follow.
Criterion (7) is similar to criteria (2) and (3) in its attempt to exclude
other financial disclosures. However, quarterly earnings announcements
accompanied approximately 45 percent of the total sample. Therefore,
results are presented for three (collectively exhaustive) subsamples: (a)
forecasts accompanied by no previously undisclosed quarterly earnings
(183); (b) forecasts accompanied by previously undisclosed first-quarter
earnings (66); and (c) forecasts accompanied by previously undisclosed
second-quarter earnings (87).
Since only feature articles on firms were used, even those forecasts in
class (a) above are usually accompanied by historical data, almost always
4Daily price data for this period was obtained from the Wells Fargo Daily Rate
of Return Tape constructed by Professor Myron Scholes of the University of Chicago.
The version of the tape used covered the period July 1962 to July 1969 and included
stock price, dividend, and capital change (stock split and stock dividend) informa-
tion.
including the previous year's earnings per share. Comparison of this num-
ber to data contained either in the COMPUSTAT data tape or Moody's
Manuals revealed that in most (but not all) cases, the article had presented
the previous year's primary earnings per share, adjusted for gross capital
changes (i.e., stock splits subsequent to the prior year's annual report
were noted). Thus while the forecaster himself was not quoted as speci-
fying primary (as opposed to fully diluted) earnings per share, a primary
e.p.s. number was presented for comparison. In several cases, the fore-
caster did mention that his forecast included allowances for incipient
acquisitions or recent extraordinary gains or losses.
Finally, criterion (8) excluded forty-three forecasts which satisfied the
previous seven criteria. The price behavior accompanying these forecasts,
which were released as revisions (25) or reiterations (18) of previous fore-
casts, did not appear to differ from the "first release only" sample. How-
ever, usually the four-month test periods (discussed below) overlapped,
resulting in some double counting of the same price data. For this reason,
the revised and repeated forecasts were excluded.
The entire sample is characterized by the obvious bias of self-selection:
only those firms that voluntarily chose to publish management forecasts
of earnings per share are included. While no motive for this behavior is
imputed here, it is not possible to identify separately corresponding sam-
ples of firms who either deliberately suppressed or chose not to prepare a
prediction.5 Therefore, it may be misleading to infer from the results
presented here the possible stock price behavior of firms that would be
legally obligated to publish forecasts they would not voluntarily disclose.
The results are intended to indicate the price behavior which was associ-
ated with the voluntary disclosure strategy. Any further biases introduced
by the eight selection criteria are probably small in comparison to the
self-selection problem.
Criterion (1) limits the sample to firms of sufficient size and stability to
merit listing on the New York Stock Exchange. The composition of the
sample by industry group is presented in table 1. The largest industry
grouping is the utilities, comprising 15.5 percent of the sample. In the
empirical analysis, these fifty-two forecasts are examined as a subsample.
Table 2 illustrates the number of "multiple observations" available.
About 21 percent of the firms selected made more than one forecast be-
tween 1963 and 1967, but only twelve firms made more than two. Table
5
A randomly selected control group could have been used to check for systematic
violations of the null hypotheses by all firms in the market during the time period
1963-67. Examination of the sample firms' regression statistics and residual plots for
their four-year estimation periods did not indicate any abnormal time-period effects.
Cheever [1975] provides an industry-matched control group and compares price
variability at forecast disclosure for the test group to price variability at contem-
poraneous "significant event" disclosure for the control group. This tactic is aimed
at comparing forecasts to other types of disclosures, although it may also isolate
time-period anomalies.
252 JAMES M. PATELL
TABLE 1
Industry Composition of Sample
Industry Forecasts Firms
Utility.................................................... 52 37
Machinery............................................... 31 26
Chemical
(inc. Gypsum)..
28 18
Motor Vehicle, Aircraft, Ships
.24 20
Petroleum Refining .18 12
Food .15 13
Wholesale & Retail .14 11
Finance................................................... 14 11
Glass, Ceramics,
Cement .................................. 13 9
Steel & Nonferrous Metals .12 8
Electrical................................................. 11 9
Metal Work ............................................... 10 7
Leisure & Motion Picture .10 6
Paper..................................................... 9 7
Railroad................................................... 8 7
Precision Machinery ....................................... 7 7
Holding Co. & Conglomerates .7 7
Rubber & Plastic .7 6
Coal .6 5
Forest Products & Home Furnishings .6 5
Communications. .......................................... 6 4
Mining-Metals .5 5
Crude Oil Production .5 4
Textile.................................................... 5 4
Construction ............................................ 4 3
Publishing & Printing
.4 3
Natural Gas Transmission .3 2
Trucking & Air Transport
.2 2
TOTAL.................................................... 336 258
3 shows the distribution of forecasts by year.6 Table 4 segregates the
sample by fiscal quarter of release and by forecast type (i.e., whether the
forecast was accompanied by first- or second-quarter operating results).
Fifty-four percent of the total sample consists of forecasts unaccompanied
by initial disclosure of quarterly earnings. This percentage is relatively
stable, varying between 52 and 58 percent within the three fiscal quarters
included. Sixty-three forecasts (18.8 percent) were issued by the fifty-
four non-December 31 fiscal year firms in the sample.
6
Table 3 indicates that the number of forecasts satisfying the selection criteria
declined through time. Actually, the total numbers of forecasts increased slightly,
but the proportion of excluded forecasts (chiefly for over-the-counter stocks)
in-
creased at a faster rate.
TABLE 2 TABLE 3
Multiple Observations Distribution of Forecasts by Year
Multiple Forecasts Firms Forecasts Year Forecasts
I.......... 194 194 1963 79
2........... 52 104 1964 83
3........... 10 30 1965 63
4........... 2 8 1966 57
1967 54
Total 258 336 336
TABLE 4
Distribution of Forecasts by Quarter and Type
Quarter
Type Total
1 2 3 4
Forecast only
.34 90 59 0 183
Forecast + 1st-quarter results 24 42 0 0 66
Forecast + 2d-quarter results. 0 39 48 0 87
TOTAL .58 171 107 0 336
3. Definition of Variables
The following variables are defined for each firm on a weekly basis:
Rit
=
In [Pit
+
Dt]
Pi't-1
RIm = In PX-]
Dit
=
cash dividend
paid per
share of firm i in week t.
Pit
= closing price per share of firm i at end of week t.
,
= closing price per share of firm i at end of week t - 1, adjusted
for stock splits and stock dividends.
(SP)
=
closing
value of Standard & Poor's
Composite
Price Index at
end of week t.
Rit is the natural logarithm of the price relative and can be viewed as
a continuously compounded rate of return. The price relatives are com-
puted at Friday (or last trading day of week t) closing. RJmt is the analogous
measure for the value-weighted portfolio consisting of the firms in the
Standard and Poor's 500 Composite Index (also measured at Friday closing).
Despite the many shortcomings of this index (see Fisher [1966]), one
of the most notable being omission of dividends, it has the advantage of
being readily available on a daily basis.
The price relative history is divided into a forecast period, in which
254 JAMES M. PATELL
the price activity is examined, and a nonforecast period used for estimation
of coefficients of a linear market model. The forecast period consists of
the week of forecast disclosure, the eight preceding weeks, and the eight
following weeks. While an eight-week preforecast examination may be too
short to capture all anticipatory price movements, it did allow observation
of statistically significant cumulative trends, discussed in section 7. The
nonforecast period consists of the two years preceding and the two years
following the forecast period. Many firms had less than a full 208 weekly
observations due to stock price data inavailability (e.g., merger within
two years following the forecast), but in no case were less than ninety-
five weekly observations available.
To provide a point of reference, the tests applied during the forecast
period are also applied to the firm's price data at the date of the announce-
ment of annual earnings in the Wall Street Journal. An earnings report
period of seventeen weeks centered on the week of the earliest announce-
ment following the end of the fiscal year7 can thus provide a measure of
comparative magnitude of price change effects between forecast and
outcome. Due to the relatively small number of non-December 31 fiscal
year firms8 (sixty-three observations on fifty-four firms), this provides
only a weak replication of the Beaver study, although the results are in
agreement.
4. Test Procedures
The market model of Sharpe [1964] and Lintner [1965] is used to elimi-
nate market-wide elements of price change. The model specifies a linear
ex-ante relation between the return on the shares of firm i and the return
on the market portfolio (a value-weighted aggregation of all risky se-
curities available for investment, approximated in this study by the Stan-
dard and Poor's Composite Stock Price Index).
R7i
= at+ iRm+ +
0
i i = 1 ...
N,
firm index
1 ...
T, week index, (1)
nonforecast period.
Ordinary least-squares regression is performed on realizations of R1i
and Rmr to obtain estimates ai and bi
of ai and fi, respectively. As dis-
cussed in Fama [1968], Beja [1972], and Fama [1973], this estimation
technique assumes that the joint distribution of returns is stationary
7
In view of the results shown by Foster [1973], the earnings announcement date
was set at the date of earliest disclosure in the Wall Street Journal (whether formal
announcement, preliminary announcement, or company estimate). Estimates oc-
curring prior to the end of the fiscal year were not considered.
8 The Beaver [1968] study uses a sample of 143 non-December 31 firms, releasing a
total of 506 annual earnings announcements.
through time and that:
E(ei)
= o
(2a)
cov
(4
e i
{a0ji2
y
(=2b)
COV (fiRmr) -0 y? T = 1... T. i= 1 ***N. (2c)
The time-series regression also provides an unbiased estimate of
o-i2,
the
variance of the residuals during the estimation period.9
r=bT
2
2
T2= (3)
These estimated coefficients are used to form predictions of
Rit , with
resulting prediction errors, during the forecast period (-8 < t < +8).
Since the errors are estimated for observations which were not used in
the estimation of
ai
and bi, they are not residuals in the strict O.L.S.
sense. The prediction error is defined as:
fit
=
Rit- (ai + bifmt) t = -8 *-- +8.
(4)
Under the ordinary least-squares regression assumptions,
and the
hy-
pothesis that these assumptions hold during the forecast period,
the
fitt
are distributed such that:
E(ilit)
= o
(5a)
cov (us 2 fit)
=
{
Fs-
tj
(5b)
cov (,it X Rmt)
=O st =-8 + 8, i = 1* N.
(5c)
In order to apply a test of significance, the further,
more restrictive as-
sumptions are made that the return distributions are Normal and that:
cov
(fiit 2 fijt) =
citai22
i
_ }t=-8**+ (5d)
This cross-sectional independence of residuals during
the forecast
period
ignores correlations such as the industry effects noted
by King [1966]
for
those pairs of firms for which the forecast period
week t is the same chrono-
9
The estimate used in Beaver [1968] is defined with a denominator of T:
l T
Si
=
-d
Z
T re1
256 JAMES M. PATELL
logical week for each. C0t reflects the increase in variance due to prediction
outside the estimation period.10
1 (Rmt -m)2
(6a)
( (RmT -im)
T1
T = number of weeks in nonforecast (estimation) period.
T
iiRm = T~Z RmT.
(6b) n
T =1
Since iiit is a function of only a. and bi, it is distributed independently
of
si2, and the following two independent random variables may be formed.
Standardized Prediction Error:
uji
it
.-'
N(O, 1) (7a)
atvcit
(T -2)
Si
X2(
-
2). (7b)
hi2
Therefore, under conditions (5a) -(5d), the following ratio is distributed
as a Student t statistic with T
-
2 degrees of freedom:
Vit
=
i t
t(T-2). (8)
Further, it is possible to sum the standardized prediction errors to form
the cumulative (through time) prediction error. Denoting the number of
weeks in the accumulation by L (L < 17), a second t statistic can
be
constructed:
Normalized Cumulative Prediction Error:
1L t
i
N(
(9a)
L
WiL
=
E
-it
'-t(T- 2). (9b)
t=l
s-V'LCjt
The number of observations, T, in each firm's nonforecast period may vary
across firms due to differences in data availability. If this is denoted by a
subscript attached to T, each t statistic has an expected value of zero and
a variance equal to
(Ti
-
2)/(Tj
-4).
10
This form can be readily derived from the general form:
E[u*u*'] =
u2[X*(XIX)-1X*I + I].
See Theil [1971, pp. 122-23].
The distributions of
Vj,
and WiL implied by the previous assumptions
allow the performance of a significance test similar to the Z-test used by
May [1971] and the tests employed by Jaffe [1974a; 1974b] and Mandelker
[1974]. The Vit are assumed to be independent random variables with
known expected value and (perhaps unequal) variances, and in accordance
with the Lindeberg Central Limit Theorem,'1 a normalized sum can be
formed:
N
E7 Vi t
Zv- i=1 (10)
Nt=
Ti
- 2-
N
EWiL
ZWL -(1
1)
NE
Tj
- 2
1
(12
fTil-4
If the Lindeberg condition is satisfied, the distributions of
Zv,
and ZWL
tend to the unit Normal for large
N,
and the statistics can provide either
two- or one-sided tests of the following hypotheses:
HN1 The expected value of Vit is equal to 0, versus
HAI
The
expected
value of
Vit
is not
equal
to (is greater than/less
than) 0.
HN2
The
expected
value of
WiL
is
equal
to 0, versus
HA2
The
expected
value of
WiL
is not
equal
to (is greater than/less
than) 0.
The intention of the first two tests is to demonstrate whether the release
of an earnings forecast is associated with a prediction error of the (firm-
specific portion of the) stock price return which is not expected to average
out to zero. A third significance test, very similar to the first, can be con-
structed directly from equation (8). Squaring Vit produces an F statistic.
2
tt
s2
F(1, Ti
-
2) (12)
E [citt2l = -__ 4 1. (13)
For comparability across firms whose T, values differ, the ratio can be
standardized to yield an expected value of 1.12
11
See Feller [1966, p. 256]. Note that the Z-statistic treats each firm's residual as a
drawing from a univariate distribution, rather than estimating a multivariate (across
firms) distribution. Satisfaction of the Lindeberg condition will be discussed with the
empirical results for the nonforecast period.
12 From n. 9 above, the expected value of the statistic Uit as defined by Beaver
[1968] is:
T-4
258 JAMES M. PATELL
u - Ut Ti
-
4 Uit=
Cis2 '
(14)
E[Uit]
1 (15a)
Var [Uit]
2(Ti )
(15b)
(Ti 6)(5)
By applying the Lindeberg Central Limit Theorem again, an approxi-
mately unit Normal variate can be constructed:
N
E
i
(Ut1)
Zue
=(t )12
(16)
Lt=1 (T(-6) -
Significance tests can be performed on the following hypothesis:
HN3
: The mean of the ratio
Uit
for the forecast release week is
equal
to
1, versus
HA3
: The mean of the ratio
Ust
for the forecast release week is not
equal to (is greater than/less than) 1.
Uit is essentially the same statistic used by Beaver
[1968],
bearing the
same notation. Since Uit is constructed directly from
Vi,,
both statistics
measure some of the same effects. If the expected value of
fit,
is not equal
to 0, but its variance remains Ciff12, both
Vit
and
Ui,
will signal rejection
of their respective null hypotheses. While
Vit
is primarily a measure of
change in expected
value, Uit
cannot be considered a test solely of in-
creased variance during the forecast period, since it measures the pre-
diction errors as deviations from the hypothesized mean value of 0. Con-
versely, if the expected value of iit is equal to 0, but the variance is greater
than Ci0aiQ, Uit
will (correctly) signal rejection of its null hypothesis.
Under this condition, one may expect small values of
Vit.
However, it
is evident from equations (7) and (8) that if the variance of fi4 exceeds
Cita
2
(while the variance of the residuals during the estimation period
remains aoQ2), the numerator of Vit is overstated, and Vit is biased upward
toward rejection of its null hypothesis. Therefore, both Vit and Uit must
be viewed as tests of the single hypothesis that the regression-prediction
assumptions (5a) and (5b) are both valid for the week of forecast dis-
closure. Vit corresponds closely, but imperfectly, to a test of (5a), and
only in the event of the acceptance of (5a) (E[fiit]
= 0) can
Ui,
be viewed
as a direct test of increased variance. The values of both statistics will
be reported for all tests.
Each of the preceding tests is accompanied by a nonparametric test
used by Foster [1973], similar to one originally proposed by May [1971].
This test examines the magnitude of Vit (or Uit) for the forecast release
week in comparison to the magnitude of Vit (or Uit) for the surrounding
sixteen weeks of the forecast period. The null hypothesis
of the test states
that each of the seventeen weeks of the forecast period
for each firm has
an equal chance of containing the largest value of Vit recorded during
the period. A Kolmogorov-Smirnov One-Sample
Test is used to test this
hypothesis against the (one-sided) alternative that the largest value of
Vie is more likely to occur during the forecast release week.
HN4: The probability of the largest value of Vie occurring in the
forecast release week (or any other week in the period) is
7r=
Y17
HA4:
The
probability
of the largest
value of
Vit occurring in the
forecast release week is or > 117
5. Estimation Results in the Nonforecast Period
The nonforecast period for each firm consisted of the two years prior
to and the two years following the seventeen-week forecast period. Table 5
summarizes the regression results from the weekly price relative data.
The average value of 1.0000 for bi indicates that the total sample, viewed
as an equally weighted portfolio, bears a systematic risk virtually identical
to that of the Standard and Poor's 500 Composite. This close correspondence
to the market portfolio is uncontrived, for any forecast which satisfied
the selection criteria was included. Since this process is essentially one of
self-selection by the firm in choosing to issue a forecast, it does not seem
that "voluntary forecasters" are members of a particular portion of the
systematic risk spectrum.
The average value of R2 (.1575) corresponds to the value reported by
Kaplan and Roll [1972] for weekly data for the same time period (1963-
68). The average first-order serial correlation coefficient (ps) and Durbin-
Watson Statistic (D-W) indicate a very slight negative autocorrelation
of the residuals. This persisted through the forecast period, where the
average serial correlation coefficient of the prediction errors was -0.044.
TABLE 5
Price-Relative Regression Statistics in the Nonforecast Period
Decile Ti ai bi
R2 Sj2 Ps D-W Cit
.10 ... 136 -0.0015 0.4504 0.0503 0.0004 -0.2109 1.9584 1.0049
.20 ... 148 -0.0003 0.5856 0.0743 0.0005 -0.1598 2.0269 1.0053
.30 ... 173 0.0002 0.7066 0.1017 0.0006 -0.1341 2.0729 1.0055
.40 ... 188 0.0008 0.8167 0.1221 0.0008 -0.1128 2.1159 1.0057
.50 .. 197 0.0012 0.9408 0.1442 0.0009 -0.0892 2.1632 1.0060
.60... 208 0.0017 1.0617 0.1716 0.0011 -0.0707 2.2062 1.0065
.70... 208 0.0023 1.1897 0.1957 0.0012 -0.0473 2.2401 1.0071
.80 ... 208 0.0030 1.3435 0.2200 0.0016 -0.0269 2.2887 1.0090
.90 ... 208 0.0040 1.5403 0.2656 0.0021 +0.0009 2.3799 1.0111
Mean. 184.1 0.0014 1.0000 0.1575 0.0011 -0.0920 2.1702 1.0081
260 JAMES M. PATELL
Ti, the number of price-relative observations used for estimation, varies
due to data availability. As shown in equation (6), it is the primary in-
fluence on the magnitude of Cit, the prediction variance adjustment.
(The values of Cit
shown in table 5 are for t = 0, the forecast week. The
values for other weeks within the forecast period are similar.) The average
value of 1.0081 for Cit indicates that its omission would have added less
than a 1 percent average upward bias to the test statistics. The minimum
value of Ti (not shown), is 95, which corresponds to the maximum value
of Cit of 1.0831.
The variances of both Vit and Uit are functions of
Ti
alone, and there-
fore the differences in
Ti
across firms determine the extent to which the
Lindeberg condition is satisfied in forming the Z statistics. Essentially,
the Lindeberg condition demands that each observation's contribution
to the summed theoretical variances in the denominator of Z be small in
comparison to the total summation."3 For the total sample, Ti lies between
95 and 208, and thus the theoretical variances of the Vit and WiL lie be-
tween a minimum of 1.010 and a maximum of 1.022, a difference of only
1.2 percent of the minimum value. Similarly, the theoretical variances of
the Uit lie between 2.030 and 2.067, a difference of 1.9 percent of the mini-
mum value. Therefore, even in subsamples of relatively small
N,
the
Lindeberg condition should be satisfied.
6. Price Movement during the Forecast Period
Table 6 presents the mean values of Vit and Uit (denoted V1 and Ut)
for the full sample. The columns labeled P(Zv,) and P(Zut) are the prob-
abilities, computed using the Lindeberg
Z Statistic, for two-sided tests of
hypotheses HNl and HN3. They represent the probability of observing
values of Vt
and Ut
more extreme (in either the positive or negative direc-
tion) than those obtained in the sample, under the hypothesis that the
14
mean and variance of iiit are unchanged during the forecast period.
On average, the firms experienced large positive values of
iiit during
the week of forecast disclosure (t
=
0), with an average standardized pre-
diction error of +0.194. The probability
of obtaining a value more ex-
treme than Vt for week t = 0 is 0.0004 under the null hypothesis HN1,
and the null hypothesis would not be rejected
at the 0.05 probability level
for any other week in the test period.
Thus the observed
Vit
values indi-
cate that the forecast disclosure week (alone)
was the occasion of sta-
tistically significant price revisions.
13
See Feller, [1966, p. 256].
14
Two-sided probability values are used in examining the full test period in order
to include movements both above and below the hypothesized expected value of
Vit and Uit during weeks other than the forecast week itself (t
=
0). In subsequent
tests focusing on week t = 0 alone, more powerful one-sided tests are used. To convert
table 6 to one-sided tests (e.g., to consider the one-sided alternative E(Uit) < 1
for t > 0), divide the listed probabilities by 2.
TABLE 6
Forecast Period Statistics for Full Sample
Week V,
P(Zvt)
EltP(Zut)
two-sided two-sided
-8 . ............ -0.046 .401 0.774 .004
-7 . ....... -0.019 .726 0.921 .312
-6 . ....... -0.029 .589 0.913 .263
-5 . ....... +0.031 .569 0.912 .258
-4 . ............ +0.046 .401 0.907 .234
-3 . ............ -0.020 .711 1.020 .795
-2 . ....... +0.002 .976 0.828 .027
-1............. +0.093 .091 0.913 .263
0............. +0.194 .0004 1.108 .165
+ 1............. -0.074 .117 0.755 .002
+ 2............. +0.023 .674 0.847 .050
+3 . ....... -0.095 .082 0.811 .015
+4 . ............ -0.067 .226 0.764 .002
+5 . ............ -0.069 .208 0.880 .124
+ 6............. +0.086 .116 0.830 .029
+7 . ............ -0.052 .337 0.865 .082
+ 8............. - 0.086 .119 0.793 .008
The
U,
values are less than 1.0 for all test period weeks except t = -3
and t = 0, and the probability values are quite low for the weeks following
forecast disclosure. If the hypothesis E(fiit)
= 0 is accepted for the weeks
following forecast disclosure, then
Ui,
can be interpreted as a test for
changes in the variance of
ii,
. The observed
Ui,
values indicate that the
period immediately following the price revision at the date of forecast
disclosure was one of very low (firm-specific) variability in rates of return.
Since the hypothesis E(fijt)
=
0 is rejected for the forecast week itself,
the variance change interpretation of Uit is inappropriate for that week."5
As noted by May [1971], the Uit measure is more sensitive to a small
proportion of large values of fiit, as would be expected when dealing with
squared values. The mean value of
Vi,
lies close to its median value, and
the time plot of Vt is contained entirely between the 40 and 60 percent
deciles. The time plot of Ut lies entirely above the 60 percent decile and is
above the 70 percent decile for thirteen of the seventeen weeks, which is
consistent with the assumed F distribution of Uit. The behavior of week
15
Table 6 indicates that the average value of Uit is depressed (less than 1.0)
throughout almost the entire forecast period. This may be due to the exclusion of
all fourth-quarter forecasts and their associated price residuals. Generally, the over-
all dispersion of first- and fourth-quarter residuals is greater than that of second-
and third-quarter residuals for the firms in this sample. Figure 2 shows that residuals
taken around the annual earnings report at fiscal year end have a higher average
Uit . The general "noisiness" of the first and fourth quarters reduces the sensitivity
of residual tests, such as the ones reported here, during those quarters.
262 JAMES M. PATELL
TABLE 7
Forecast Weck Statistics
Sample N Vt=o P(Zv)* P(KSV)* Ut=o
P(Zv)*
P(KSU)*
Total........ 336 0.194 .0002 .0001 1.108 .0823 .0008
Point........ 204 0.167 .0089 .0022 1.066 .2546 .0005
Level ........ 132 0.237 .0035 .0430 1.173 .0823 .3372
Utility ..... 52 0.082 .2776 .0437 1.233 .1210 .1092
Nonutility... 284 0.215 .0002 .0001 1.085 .1587 .0028
*
One-sided test.
t = -3 is interesting in this regard. The value of Vf for t = -3 is -0.020,
and only two of the sixteen other weeks have values of Vt closer to zero.
Conversely, Ut for t = -3 is 1.020, and only the forecast week itself has
a larger value. Thus, taken alone, the Uit measure indicates a similarity
between weeks t = -3 and t = 0, while the
Vit measure shows that the
forecast week is characterized by a majority of large positive price-rela-
tive prediction errors, and week t = -3 is characterized by a more even
split of positive and negative values, whose dispersion about zero is en-
larged."6
Table 7 contains the values of
Vt and Ut
for the forecast week only, for
selected subsamples. The columns labeled P(Zv) and P(Zu) contain the
probability values for one-sided hypothesis tests of HN1 and HN3 . The col-
umns labeled P(KSv) and P(KSu) indicate the probabilities, computed
from the Kolmogorov-Smirnov test, of the accompanying HN4 hypotheses;
they represent the probability of the observed frequency with which the
maximum value of
Vit (or Uit) occurred in the forecast disclosure week,
under the hypothesis that the maximum value is equally likely to occur in
any of the forecast period weeks.
The probability values for the V0 tests, with the exception of the utility
subsample, are below 0.01. There does not appear to be a significant
difference between the point estimate and level estimate ("earnings will
be at least . . .") subsamples, but the utility subsample exhibits a much
weaker effect than the nonutilities. The K-S test values, which essentially
compare the forecast week to its immediate neighbors rather than to the
surrounding four-year nonforecast period, are also very small, with a value
of .0001 for the full sample.
The probabilities of occurrence of the U0 values are less striking in
magnitude. The probability of obtaining a value greater than the full
sample U0 is 0.0823 under the null hypothesis. Here, the level estimate
subsample exhibits a smaller probability value than the point estimate
16
Cheever [1975] presents an analysis of daily price data at the disclosure date of
forty-six management forecasts using the Ut measure as defined by Beaver (see nn.
9 and 12 above) and reports
Ut
values greater than 1.0 for the date of forecast dis-
closure.
subsample, and the utilities resemble more the sample as a whole (due to
the same phenomenon discussed previously for week t = -3 of the full
sample) .17
In order to provide a point of reference, the tests were also performed
on the seventeen-week period centered on the week of the firm's disclosure
of its annual earnings for the year in which the forecast was made. This
comparison was motivated by the fact that the full sample value of Oo
(1.108) is very small in comparison to the value of 1.67 reported by Beaver
[1968] for the annual earnings announcements of 143 noncalendar year
firms. Beaver noted that since the majority of N.Y.S.E. firms follow a
calendar fiscal year, their annual earnings announcements will tend to
cluster in the following first quarter. Removal of the market-wide effects
at this time may also remove much of the effect we are seeking to isolate.
Therefore, as a check, the full sample is segregated into December 31 and
non-December 31 firms. Figures 1 and 2 present the time plots of
Vt and Ut respectively, with a solid line representing the forecast period
activity and a broken line indicating the earnings report period activity.
The upper plate contains the full sample, the middle plate contains the 273
calendar year forecasts and reports, and the bottom plate contains the
sixty-three noncalendar year forecasts and reports. Table 8 gives numerical
values for both statistics for week t = 0.
Figure 1 and table 8 indicate that with regard to the
Vit measure, which
considers the sign and magnitude of uiit , the rate of return activity for
forecasts is similar to the activity associated with annual earnings an-
nouncements, for both December 31 and non-December 31 firms. The values
for V0 are virtually identical for the full sample and both subsamples,
while the values of Vt
for weeks other than t = 0 are generally greater
for the earnings report period. Since the non-December 31 subsample is
so small (sixty-three observations), the apparent increase in volatility
throughout the forecast and report periods may be a function of either
the small N or the improper exclusion of some market-wide activity for
the December 31 sample.
Figure 2 and table 8 indicate that with regard to the U7t measure, which
considers the squared value of
utt,
the activity during the earnings report
period is larger than that during the forecast period. The U0 value of 1.466
17
The
P(Zvt)
and P(Zut)
for weeks other than the forecast week have been omitted
from table 7 for brevity. Using the one-sided hypothesis test for
Vt , no other test
period weeks contained positive price revisions with probability values of less than
0.01 for any of the subsamples given in table 7. (Week t = -1 for the nonutility
sample contained a probability value of .035, the smallest t 5z 0 value.) When the
less powerful (higher
Zvt
value required for rejection) two-sided test was performed
as in table 6, week +8 for the level subsample and weeks -7 and -5 for the utility
subsample exhibited negative price changes with probability values .041, .011, and
.029 respectively. No other values below .05 were achieved. The P(Zut) values re-
semble those of the sample as a whole, with various weeks after the forecast dis-
closure (t > 0) exhibitingsignificantly negative Zut(Ut < 1)
values.
264 JAMES M. PATELL
+0.~~
?.? X if fi F - f t = F ii~~~~~~~~~~~~~~~~~~~~~~~4H
:.I;tl@ '-'t-,4,., ,_,,- t.:
1
0;!|t'-4~4[v--t.0[.i'..t--t - - -
-0 + - * L _ ,'IVE 0|'+ t--+-t~wX-*w- * -..!_ .j _t ,-!.4_..__._ ... ... ,..t
_-0 .2_._ * _. _>-wi-+-. - o-8-- i
_
n
;... _ ;. .._._ ;t _ _ _...g _
2t4X.; .- L : . _ . 7t"!: :
+0.2
F=@-i|9_< t i; X _ _
0 ., 0
I|,4}?tf-@-
t
0.O|,:lt~~t..,>l t Xl';,ifitf~d Nl..t.'t; l', i T ;B 1,*.... .........
........
, :: w i '. : ,: -. ..- ..: . -. .,. - @ t + .. g f .... ... ... t '-
'~~~~~~~~~~~~~~.: -t: .-- ----|-;.:- J,
,
t 4t:ItN :/
-O.- n :
. '.r 1. . . -. t t>* 4*t1-ft~
,,,,,t,,,tS..,,}..~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~ ~ ~~~~~~~~~..... .....,. ..-,e,-,
.....,.-,.-, .... ..E'{''1 4
J-
n ? 8|
-4
|,- l . {
.
_ _
-
:,
- t
_1:
::.
I. - 1 .- | . - . _.
,: _, I.4_
r
i; t i: +4ti ;ltilti -:l r S ! -:: ii
.......... .,;.,_1 :|:i , L- .... .........
i- t 4 *t - t: : :; - : ; t - t * | t t t
+0 2< e - 7
=..-F=-'.X-..2w:~~~~~~~~~~~~~~~~~~~--
..
';41,~t .. ..
F;AD~ NO. i
--
SCIENC - ~ I
SQURE TOCNIEE
FIG 1.- Vt: foeat(oiln)v.rprt(rknln)
fo
+hio-eebr3
annsreot oiae h Ovleo
1.143~~~~~~~~~~~~~~~~~~~4 foThVaefrs oecssad osdrn tesalsml ie
is not
inconsis~~~~~~~:-ten
ihteBae 16]vle h xrm niies
of the non-ecember 31 orecast an report perods
mayMbe
ttributabl
toth malsape ie eatv t hefgue o eae [98]ad a
rlarll~~~~~7=v
FIG. I.-ct
tha
fotrtecs
(soidg line)casts repor (boeaningrepotsar
1.2 Xg gW
-t , t t
It
s
Pm
10B +F7
X lEXIM7 TXtmX %
Wtz
F7 X
10
t
XS 11g~ -F W gX CX
i; W g ltH X5 t Tv
IvT
J:7 2tlf
Wi t
l0
i-v.
1~~~~~~~~~_
V ~ ~g W w 11811llM111
wall
4-
CiTADEL0 NO 641 SOIVNOE 10 SQUARES TO CENT ME TER
0.8
CITADEL,3 NO. 641 SCI NCE - 10 SQUARES TO CENTIMETER
FIG. 2.-Ut: forecast (solid line) vs. report (broken line).
associated with statistically significant positive values of uit highlights
the problem of self-selection in the sample. The voluntary forecast dis-
closers appear, on average, to have experienced a favorable price reaction
during both the week of forecast disclosure and the eventual week of
earnings disclosure. This possible "good news" bias is examined in section
7, but it is worth noting here that for this particular sample of voluntary
forecasts during the period 1963-67, forecast disclosure was associated,
266 JAMES M. PATELL
TABLE 8
Forecast Week versus Report Week Statistics
Sample N Vt=O P(Zv)* P(KSV)* Ut=o P(ZU)* P(KSU)*
Forecast Total ...... 336 0.194 .0002 .0001 1.108 .082 .0008
Report Total ........ 336 0.200 .0001 .0008 1.172 .014 .0269
Forecast 12/31 ....... 273 0.150 .0069 .0055 1.100 .123 .0051
Report 12/31 ........ 273 0.148 .0078 .0053 1.104 .115 .0448
Forecast Non-12/31.. 63 0.388 .0011 .0057 1.143 .215 .0124
Report Non-12/31.... 63 0.427 .0004 .0072 1.466 .006 .0790
*
One-sided test.
TABLE 9
Forecast Quarter and Type Subsample Statistics
Sample N Vt=O P(ZV)* P(KSV)* Ut=o P(ZU)* P(KSU)*
First-Quarter Release. . 58 0.316 .0084 .0437 1.093 .3121 .3033
Second-Quarter Re-
lease ............... 171 0.067 .1949 .1918 1.062 .2877 .1070
Third-Quarter Release. 107 0.333 .0003 .0001 1.190 .0838 .0079
Forecast Only ......... 183 0.218 .0017 .0083 1.229 .0150 .0022
Forecast + First-
Quarter
Results ..... 66 0.177 .0764 .3578 0.997 .5040 .5895
Forecast + Second-
Quarter Results. 87 0.157 .0735 .0091 0.938 .6555 .0738
*
One-sided test.
on average, with positive stock price changes above those explained by
movements of the market as a whole.
Table 9 segregates the forecasts by fiscal quarter of release and by
type. The firm-specific price changes are less significant for first-quarter
disclosures than for third-quarter disclosures, perhaps due in part to
greater overall market volatility in the first quarter of December 31 fiscal
years. However, the second fiscal quarter results are even less significant,
and this cannot be as easily attributed to general market conditions.
With respect to accompanying disclosure of quarterly earnings, the fore-
cast-only test values exceed the forecast-plus-quarterly-earnings-announce-
ment values for all four statistics. These two (overlapping in many cases)
characteristics, forecast disclosure separate from announcement of quart-
erly results and forecast disclosure during the third quarter,
thus appear
to be associated with statistically significant price adjustment.
7. Forecasts as Changes in Expectations
This study examines the common stock price change associated with the
release of an earnings forecast with the intention of inferring
informational
content from price adjustment. Since information may be defined as
data which alters beliefs about the probability distributions of relevant
outcomes, an attempt is made in this section to approximate the beliefs
of investors about the earnings per share prospects of the firms prior to
the release of the forecasts. Comparison of these estimates of investor
expectations to the numbers predicted by company officials allows group-
ing of the forecasts by the sign and magnitude of the difference between
the two.
Three estimates of earnings expectations prior to forecast disclosure
are constructed, which correspond to the naive and regression models of
expected earnings used in Ball and Brown [1968] and Brown and Kennelly
[1972]. With the exception of the market index in model 3, the models are
based entirely on annual earnings per share data in years prior to the year
of the forecast.'8
Model 1:
E(eps,)
=
epsy,-
.
1
K
Model 2:
E(eps,)
=
epsi +
K
-
Z
(AepSd).
Model 3:
E(eps,)
=
epsy,_
+ (ai +
b2Aemy).
y, d = year indices.
K =
number of yearly observations of earnings per share prior to
the forecasted year.
Aepsd = epsd -
epSd-1.
emy
= value of Standard and Poor's Composite Earnings Index.
Aemy
=
emy -emy.
as, bi
=
coefficients estimated by ordinary least-squares regression.
Model 1 is a martingale model of earnings per share, to which model 2
appends an average additive drift. Model 3 uses the available earnings
history of the firm, up to but not including the year in which the manage-
ment forecast was released, to estimate a linear relation between first
differences in the firm's earnings per share and first differences in a market
index of earnings per share. The conditional expectation of the change in
earnings for year y, given the change in the market index of earnings
for
year y, is the right-most term of model 3.
Data on earnings histories for 178 of the firms in the sample were ob-
tained from the COMPUSTAT tape, and data on the remaining eighty firms
were compiled from Moody's Industrial, Transportation,
Public Utility,
and Bank and Finance Manuals. All
earnings per
share numbers were
adjusted to the number of shares outstanding at the date of forecast
disclosure by the firm. Table 10 summarizes the data availability and
estimation results. The average number of prior year earnings per share
18
For forecasts occurring in the second and third
quarters,
the
earnings
numbers
used by the models were publicly available several months
prior
to the forecast.
The models therefore may provide poorer
estimates of
contemporaneous
market
expectations for the later forecasts than they
do for
first-quarter
disclosures.
268 JAMES M. PATELL
TABLE 10
First Difference Earnings per Share Regression Estimates
Decile K(obs.) a b R2
Ps D-W
.10 ....... 6 -0.1960 -0.1015 0.0076 -0.5541 1.2948
.20 ....... 8 -0.0913 0.0306 0.0235 -0.4034 1.5610
.30 ....... 11 -0.0320 0.0843 0.0616 -0.3087 1.7810
.40 ....... 13 0.0055 0.1582 0.1123 -0.2298 1.9159
.50 ....... 15 0.0327 0.2690 0.1490 -0.1513 2.0793
.60 ....... 15 0.0444 0.4263 0.2079 -0.0808 2.2338
.70 ....... 16 0.0710 0.6020 0.2767 0.0054 2.3786
.80 ....... 17 0.1058 0.9092 0.3840 0.0892 2.5778
.90 ....... 18 0.1716 1.3981 0.5104 0.2563 2.7986
Mean...... 13.0 0.0115 0.5252 0.2171 -0.1406 2.0670
observations is 13, and the distribution of values for the squared correlation
coefficient (R2) and first-order serial correlation coefficient
(pa)
agree
with those reported by Ball and Brown [1968]. Quarterly values of the
Standard and Poor's Earnings Index were used to construct Aeme time
series for non-December 31 firms.
The models are used to establish three "change in expectation" measures
for each forecast.
D [Firm
Forecast-Forecast of model
j]
j 1 2 3
(17)
[Forecast of model j]
D, measures the difference between the management forecast and the
naive estimate of market expectation of earnings, expressed as a fraction
of the market expectation; D, is positive when the firm forecast exceeds
the market expectation'9 Table 11 illustrates the distributions of the three
forecast difference measures. All three have positive mean values, and
two of the three have positive median values, which sheds some light on
the self-selection bias. On average, the voluntarily disclosed forecasts of
earnings per share were greater than the naive estimates of the market's
expectation. However, the distributions vary across models. Only twenty-
seven corporate forecasts (8 percent) stated that this year's earnings per
share will be strictly less than last year's (adjusted for capital changes),
yet around one-half of the corporate forecasts projected earnings per
share strictly below the estimates of models 2 and 3. (Note, however,
that almost 30 percent of the corporate forecasts predicted no change in
earnings from the previous year.) Note also that a high absolute value of
projected earnings per share does not necessarily imply a high D, value.
The
Di
score is high (optimistic) only when the management forecast
exceeds (an estimate of) market expectations. Similarly, a low absolute
19
An alternative definition of
Dj
in which the denominator is replaced by the
sample standard deviation of prior years' earnings per share produced essentially
the same results.
TABLE 11
Distribution of Forecast Differences
Quartile Di D2 D3
1.00 ................ 2.8204 2.0710 7.9286
.75 ................. 0.1500 0.1094 0.0791
.50 ................. 0.0603 0.0215 -0.0080
.25 ................. 0.0000 -0.0342 -0.0687
.00 . -0.6364 -0.6886 -0.5428
Mean 0.1208 0.0852 0.0971
Positive ............. 211 192 157
Zero ............... 98 1 1
Negative ............ 27 143 178
TABLE 12
Forecast Difference Subsample Statistics
Sample N * Vt=o P(ZV)* P(KSV)* Ut=O P(ZU)* P(KSU)*
D1 ... 84 0.081 .2327 .1900 1.211 .0855 .0850
Lowest 25% D2 ... 84 0.244 .0132 .1246 1.389 .0062 .1382
D3 ... 84 0.254 .0104 .0138 1.221 .0793 .0850
D1 ... 84 0.341 .0010 .0003 0.913 .7123 .1900
Highest 25% D2 ... 84 0.370 .0004 .0001 0.946 .6331 .0480
D3 ... 84 0.235 .0166 .0735 0.908 .7224 .2817
D ... 168 0.198 .0054 .0061 1.324 .0016 .0072
Lower 50% D2 ... 168 0.195 .0062 .0037 1.295 .0037 .0057
J
D3. a 168 0.217 .0026 .0012 1.191 .0418 .0277
DI
... 168 0.191 .0071 .0147 0.892 .8365 .0762
Higher 50%
Y
D2 ... 168 0.194 .0062 .0093 0.921 .7611 .0861
J
D3 ... 168 0.172 .0136 .0264 1.025 .4129 .0098
*
One-sided test.
value earnings projection could be deemed optimistic if investors have
reached an even lower estimate based on other available information.
Thus, the
Dj
Value attempts to measure the optimism or pessimism of a
forecast relative to models of investor expectations prior to the date of
disclosure.
The 336 forecasts were ranked from most positive to most negative on
each of the three difference measures. As anticipated, the rankings are
essentially the same, with the D2 measure representing an intermediate
ranking between D1 and D3 . The rank order correlation coefficients between
each pair of measures are: pR(D1, D2) = 0.8775, pR(D2, D3) = 0.7155,
pR(Dl, D3) = 0.6851. Significance tests for each of the three coefficients
yield probabilities of less than 0.0001 that the three measures are unas-
sociated.
Table 12 presents the f0 and Uo statistics for the lowest (most negative)
25 and 50 percent, and the highest (most positive) 25 and 50 percent of
270 JAMES MA. PATELL
the full sample on each of the three difference measures. The firms in the
top 25 percent (firm forecast most exceeded naive expectations) experienced
significantly positive
ui,
values during the week of forecast disclosure.
However, the firms in the bottom 25 percent (firm forecast was furthest
below naive expectation) also experienced (on average) positive it ; and
for two of the three naive forecasts, the average uit had a positive magnitude
with a less than 0.02 probability of occurrence. When the firms are ag-
gregated into top and bottom halves on each of the three measures, the
V0 behavior of the two halves is essentially identical. On the UO measure,
the bottom half (management forecast below naive forecast) appears to
experience a much wider dispersion of price-relative prediction errors
during the forecast week.
Thus, when attention is restricted to only the week of forecast disclosure
itself, there appears to be very little to distinguish between forecasts on
the basis of sign or magnitude of the change in investor expectations.
However, examination of the full forecast period surrounding the week of
disclosure, through the use of the cumulative residual (see equation 9),
does indicate strongly differentiated price behavior. Figure 3 plots the
value of the average cumulative residual (
t=-17 Vt) for the entire seven-
teen weeks of the forecast period. The value at each week L is the summa-
tion from week t = -17 to week t = L and is not precisely equal to WiL,
since the normalization by 1/V/L is not yet included. The plots shown are
for forecast difference measure D2, with the upper plot for the top 50
percent of the firms on the D2 measure (168 firms), the lower plot for the
bottom 50 percent (168 firms), and the central plot for the full sample.
This figure is perhaps the most interesting of the entire study and shows
that the naive forecast models do indeed discriminate between firms.
Those firms whose management forecasts exceed market estimates ap-
pear to enjoy generally positive price-relative residuals during the two
months preceding the forecast announcement, while firms whose forecasts
fall short of market estimates experience generally negative residuals
during the preceding two months. However, the price-relative prediction
errors at the immediate announcement date are positive for both sets of
firms.
Table 13 presents the probabilities associated with the observed values
of
WiL , the normalized cumulative residual, for weeks t = -3 through
t
=
+3. The probabilities are for one-sided tests of hypothesis HN2, of
opposite sign for the two groups. For example, using the D2 measure, the
probability of observing a value of WiL larger than that experienced by
the top half of the firms in week t
=
-1 is 0.0022. Conversely, the prob-
ability of observing a value of WiL smaller (more negative) than the -0.182
experienced by the bottom half of the firms in week t
=
-1 is 0.0096.
Prior to the week t
=
0, figure 3 is similar to the Abnormal Performance
Index plots of Ball and Brown [1968] and Brown and Kennelly
[1972].
For the positive change in expectations group (top 50 percent), the activity
41 1;~1 -
+0.4
+06 2- 7
A ........
+0.4~~~~~~~~~~~~~~
~~~~~~J4 F~~~~~~~~~~~~~rFT
i~~~~~~t~ . ..~ .......
CITADELT NO 641 SCIENCE 0 SQUARES TO
CENTIMETER~~~~~~~~~~~~~~~T'
:-7. '77 ....
FIG 3 Cumulative average residuals (Zt 17 V1)~~~~~~~~~~~~~~........
at and- folwngwe t0cntne o eebl7herig anouc
metsuisAiha eka ekt 0ad usqetlvln of.20ALI
It s heboto 5 prcet ure hih s niue.Boh hepeiosJro
20Fgr-4 logve h mrsintattedvrec etentetogop
strs xctyeih wes rort tefoeas nnuceet ek.Tisi mrl
a osqeneo trtn h umaina tis on.Hdte umtoeu
ealer h dvrgneofte w rop myhveaperdata erir ae
272 JAMES M. PATELL
TABLE 13
Probabilities of Cumulative Residuals P(ZWL)-one
sided
Sample -3 -2 -1 0 +1 +2 +3
D1.. .0495 .0244 .0062 .0007 .0041 .0018 .0038
Top 50% D2. .0158 .0122 .0022 .0002 .0025 .0013 .0037
D3 .1611 .1357 .0409 .0087 .0096 .0049 .0217
D . . . 0207 .0102 .0239 .1539 .1170 .0869 .0294
Bottom 50% D2.. .0054 .0047 .0096 .0853 .0869 .0721 .0287
D3.. .0323 .0735 .1112 .4129 .1841 .1539 .1075
TABLE 14
1 N L
Uit
Average Cumulative Standardized Prediction Errors: N
E
Ei
siVICit
i=1 t=-8
Top 50% Bottom 50%
Week
Di D2 Di D2 D2 D3
-8...... -0.020 -0.045 -0.043 -0.072 -0.047 -0.049
-7 ..... -0.037 0.025 -0.074 -0.094 -0.156 -0.057
-6 ..... 0.105 0.170 -0.015 -0.294 -0.360 -0.175
-5 ..... 0.210 0.253 0.001 -0.338 -0.381 -0.128
-4 ..... 0.349 0.436 0.115 -0.384 -0.471 -0.190
-3 ..... 0.314 0.410 0.189 -0.389 -0.485 -0.265
-2 ..... 0.406 0.464 0.227 -0.478 -0.536 -0.299
-
1 ..... 0.550 0.627 0.383 -0.437 -0.514 -0.269
0...... 0.741 0.822 0.555 -0.238 -0.319 -0.052
+ 1...... 0.648 0.690 0.576 -0.294 -0.336 -0.222
+2 .... 0.751 0.779 0.664 -0.350 -0.378 -0.264
+3 .... 0.720 0.722 0.545 -0.510 -0.512 -0.355
+4 .... 0.634 0.669 0.499 -0.557 -0.592 -0.422
+5 .... 0.572 0.638 0.449 -0.634 -0.700 -0.511
+6 .... 0.613 0.706 0.496 -0.503 -0.596 -0.386
+7 .... 0.561 0.670 0.431 -0.556 -0.665 -0.425
+8 .... 0.495 0.613 0.358 -0.661 -0.779 -0.524
t= -8 to t = -2 and from t = +1 to t = +8 show a steady negative
trend in the price-relative prediction errors. However, there appears to be
a strong, although short-lived "voluntary announcement effect,"
at weeks
t
=
-1 and t =
0, which momentarily interrupts the downward trend
with a positive price adjustment. Table 14 presents the values of the aver-
age cumulative prediction errors through the seventeen-week forecast
period for each of three market expectation models. The announcement
effect is apparent in all three groupings.
The price behavior exhibited in figure 3 and table 14 is open to a num-
ber of interpretations. The anticipatory price changes prior to manage-
ment forecast disclosure are consistent with investor processing of alterna-
tive information sources concerning earnings prospects. It is important to
note that this preannouncement behavior need not imply prior leakage of
the forecast to insiders, but rather the market's efficient use of publicly
available indicators, many of which may be embodied in the management
forecast itself. In this regard, figure 3 is similar to many other API studies.
The activity at the disclosure week is less easily explained for the nega-
tive change in expectations group and may hinge on the imputed informa-
tion content of the act of voluntary disclosure. It was unfortunate that
virtually none of the forecasts included here were worded in a manner
which revealed motivation (such as "Contrary to a previous report. . .
,"
or "Despite critical shortages of . . ."). Nevertheless, for whatever reasons
the sample firms chose to make public an internal forecast of future earnings,
this action was the occasion of positive price change, even though the
market appears to have anticipated the numerical content of the disclosure.
8. Conclusions and Summary
For the time period 1963-67, the following stock price behavior has
been observed for firms which voluntarily issued forecasts of earnings per
share: (1) There was a statistically significant upward price change during
the week of forecast disclosure, beyond that explained by movement of
the market as a whole. (2) When using a measurement technique which
includes sign, the price adjustment was, on average, of the same sign and
magnitude as that which accompanied the subsequent announcement of
realized annual earnings. Using an unsigned measurement technique similar
to Beaver [1968] produced a forecast price adjustment smaller than the
earnings announcement adjustment. (3) During the two months preceding
the disclosure of the forecast, price adjustment was in the same direction
as the change in "naive" expectations embodied in the forecast. Forecasts
which exceeded estimates of market expectations were preceded by posi-
tive price adjustments, and forecasts which fell short of market expecta-
tions were preceded by negative price adjustments. (4) Regardless of
the sign of the estimated change in market expectations of future earnings,
on average, the immediate forecast week was the occasion of upward
price revision. Subsequent price behavior was relatively level for the posi-
tive forecast group and continued to decline for the negative forecast
group.
These conclusions are based on the analysis of regression prediction errors
which occur at and around the date of forecast disclosure. The tests demon-
strate the temporal association of price change and a firm's announcement,
which is distinct from the proof of causality. The tests make use of a
cross-sectional average, and it is certainly true that there are firms in the
sample which experienced negative price revisions during the forecast
week. However, after standardizing each firm's unexplained price change
by an estimate of the firm's price variability, the average change is positive
and statistically large.
274 JAMES M. PATELL
The cumulative residual analysis presented in figure 3 and tables 13
and 14 implies anticipation of the earnings number contained in a manage-
ment forecast up to two months prior to its publication. The predisclosure
price changes experienced by the firms which released forecasts below esti-
mates of the market's expectations may be tied to the self-selection nature
of the sample. It is possible that the act of voluntarily committing the
firm to a prediction of earnings per share conveys information separate
from the numerical value predicted. The firms in this sample are exactly
those which chose to step forward and announce a prediction, risking at
least the embarrassment of (if not the legal liability for) failure to produce
the forecasted performance. This act was accompanied by immediate
upward price revision (on average), with relative insensitivity to the re-
lation between the value predicted and other available forecasts. Longer-
range cumulative effects, however, appear to be consistent with the rela-
tion between the predicted value of the earnings number and other esti-
mates of market expectations.
The question of investor response to the voluntary disclosure by a firm
of data it was not legally bound to release can be examined in a number of
other contexts, such as price-level adjusted data, product line reporting,
and alternative inventory valuations. A theoretical consideration of volun-
tary disclosure in an information-economics framework also appears
interesting, since it would entail specification of both management's utility
for outcomes and its beliefs about probable reaction to disclosure. From a
behavioral or game-theoretic point of view, it might be argued that com-
mitting oneself to a prediction of future behavior subsequently alters
behavior.
Finally, the question of whether or not firms should be required to issue
forecasts of earnings involves judgments
and inferences beyond the scope
of the results reported here, on the grounds that the desirability of dis-
closure practices cannot be judged from the association of stock price
behavior.2' Further, the sample contains no firms which were legally
forced to reveal a forecast that they would not have voluntarily chosen
to disclose. However, the stock price behavior observed in this study is
consistent with the hypothesis that either the number contained in a
voluntarily disclosed management forecast, the act of voluntary disclosure
itself, or both, are perceived as conveying relevant information to in-
vestors. The fact that the forecasts are preceded by price revisions which
appear to anticipate the content of a forecast correctly may indicate
proper evaluation by investors of publicly available information, some or
all of which is contained in the management forecast. Nonetheless, the
week of forecast disclosure is a period of upward price revision (on average),
seemingly independent of market-wide expectations of earnings.
21
See Gonedes and Dopuch [1974].
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