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From The Ivory Tower Part Two

This post continues my notes in part one.

Does the midpoint of range earnings forecasts represent managers' expectations?

William Ciconte, Marcus Kirk and Jennifer Wu Tucker

Beyer, Cohen, Lys & Walther (2010) conclude that in the past decade management earnings forecasts accounted for about 55% of the accounting information used by investors.

Range forecasts are the most predominant form of management earnings forecasts and account for about 80% of all forecasts issued in the past decade.

Investors assign a premium to firms that meet or beat the analyst consensus at the earnings announcement (hereinafter "MBE") (Bartov et al. 2002)

We predict that the midpoint is a poor proxy for management expectations after 1996.

In our empirical tests, we use management earnings forecasts for fiscal quarters in 1996-2010 covered by First Call's Company Issued Guidelines (NYSE:CIG) database. We observe 46.9% of management forecasts in range form for the earlier period 1996-2001 and 80.5% for the later period 2002-2010. For the full sample, actual earnings fall above the upper bound for 41.4% of the forecasts, at the upper bound for 16.2% of the forecasts, and below the upper bound for 42.4% of the forecasts. In other words, the upper bound rather than the midpoint appears to be the central location of the distribution of actual earnings.

Our tests suggest that in the later period when managers aggressively set the midpoint of range forecasts below their earnings expectations, analysts barely unravel this bias, resulting in more beatable analyst expectations at the expense of larger analyst forecast errors.

Finally, we examine how investors interpret management range forecasts. We find that earnings news calculated with the midpoint as the proxy for managers' expected earnings no longer provides the best explanatory power for investors' price reaction at the management forecast date. Instead, the best explanatory power is obtained when managers' true earnings expectations are set to be at the upper bound of range forecasts. To corroborate this result, we group observations by management earnings news and find that stock returns are not clearly negative unless the upper bound of range forecasts falls below the prevailing analyst consensus compiled before the management forecast. These results suggest that investors do not view the midpoint as managers' true expectation but instead infer a value close to the upper bound.

Citations from the above article:

B Lansford, B Lev and J Tucker 2012 Causes and consequences of disaggregating earnings guidance. Journal of Business, Finance and Accounting

WJ Mayew 2008 Evidence of management discrimination among analysts during earnings conference calls. Journal of Accounting Research 46

DJ Skinner and RG Sloan 2002 Earnings surprises, growth expectations, and stock returns or don't let an earnings torpedo sink your portfolio.