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From The Ivory Tower Part Three

This continues with the notes started in part one.

Managers' Forecasts of Long-Term Growth in Earnings: New Information or Cheap Talk?

David S. Koo and P. Eric Yeung

Estimation of long-term growth in earnings is fundamental in valuation, but prior research suggests that forecasts of longer-term earnings growth provided by analysts are of questionable value. We identify a previously undocumented source of longer-term earnings growth projections about which there is virtually no prior evidence - managers' forecasts of longer-term growth. These forecasts have the unique characteristic of being relatively difficult to verify, and so we begin by investigating whether they provide new information, or are simply cheap talk. We hand-collect a sample of managers' forecasts of longer-term earnings growth and find that these forecasts are significantly optimistically biased, ranging from two to five times the realized future growth rates. They also tend to convey good news relative to analysts' growth forecasts, which are themselves optimistic. Despite this over optimism, managers' growth forecasts on average convey new information about the firm's future realized growth that is incremental to that contained in analysts' growth forecasts. However, this result is driven primarily by forecasts conveying bad news (which are less optimistically biased). In contrast, growth forecasts conveying good news are on average uninformative cheap talk, and evidence suggests that these managers overweight their firm's historical growth rates. Analysts, but not investors, appear to understand that managers' bad news growth forecasts are more informative than their good news forecasts. Even so, our evidence suggests that analysts underreact to bad news management growth forecasts and overreact to good news forecasts.

Literature has largely focused on managers' short-term forecasts of current period quarterly or annual earnings. However, expectations of long-term growth in earnings are even more critical in estimating the cost of capital and firm value (e.g., Ohlson 1995; Chan, Karceski, and Lakonishok 2003; Botosan and Plumlee 2005).

Prior research concludes that analysts' forecasts of longer-term growth in earnings are not only overly optimistic, but also are negatively related to future returns, leading many to question their usefulness (e.g., LaPorta 1996; Dechow and Sloan 1997; Chan et al. 2003; Bradshaw 2004; Barniv, Hope, Myring, and Thomas 2009; Jung, Shane, and Yang 2012)

Analysts - but not investors - at least partially appreciate the differential informativeness of bad versus good news management growth forecasts. Analysts incorporate the news in manager's growth forecasts into their own growth forecasts, revising more strongly in response to a unit of bad news than to a unit of good news of growth forecast surprise. Nonetheless, analysts do not fully appreciate the differential informativeness of managers' bad news growth forecasts: they still underreact to bad news and overreact to good news in managers' growth forecasts.

Analysis of post-management-growth-forecast returns over the following three years suggests investors underreact to bad news and overreact to good news at the growth forecast announcement date, and these misperceptions do not begin to be corrected until two years later when the forecasted growth fails to materialize.

A Unified Framework of Management Earnings Forecasts: Voluntary, Disclose or Abstain, and Opportunistic Incentives

Edward Li, Charles Wasley & Jerold Zimmerman

An additional economic rationale for managers to issue MEFs (Management Earning Forecasts) has received little (if any) attention in the literature namely, regulations imposed by the Securities Acts and stock exchanges requiring managers to disclose any material information they have prior to trading in their firm securities (e.g., Loss and Seligman 2004 and Heitzman, et al. 2010). Specifically, SEC Rule 10b-5 prohibits insiders from trading based on material information. Insiders must either disclose their material information or abstain from trading. Thus, an additional rationale for managers to issue MEFs is to comply with these regulations, because MEFs are a simple and effective way for managers to disclose material information prior to trading in their firm's securities.

While the literature recognizes that MEFs are issued for a variety of reasons, no study comprehensively examines the alternative explanations. Rather, a typical study assumes one motive for why MEFs are released.

Using a sample of 23,144 MEFs obtained from the First Call database from 1998 - 2007, we classify 15,571 (68.1%) as voluntary MEFs, 4,237 (18.3%) as DOA (Disclose Or Abstain from trading) MEFs, and 3,156 (13.6%) as opportunistic MEFs. While 68.1% of all MEFs are classified as voluntary, a substantial portion (31.9%) is not. MEFs classified as DOA are more likely to be issued concurrently with an earnings announcement (76%) than opportunistic MEFs (52%) or voluntary MEFs (59%). DOA MEFs are more likely to have insider trading in the five days following the MEF's release than opportunistic MEFs, and, given there is insider trading in the five days following the MEF's release, the intensity of that insider trading following DOA MEFs is greater than that in the same five day window following the release of either a voluntary or an opportunistic MEF.