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Earnings response elasticity and post-earnings-announcement drift

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Abstract

This article studies the relationship between initial market response to earnings surprise and subsequent stock price movement. We first develop a new measure – the earnings response elasticity (ERE) – to capture initial market response. It is defined as the absolute value of earnings announcement abnormal returns (EAARs) divided by the earnings surprise. The ERE is then examined under various categories contingent on the signs of earnings surprises (+/−/0) and EAARs (+/−). We find that a weaker initial market reaction to earnings surprises, or lower ERE, leads to a larger post-announcement drift. A trading strategy of taking a long position in stocks in the lowest ERE quintile when both earnings surprises and EAARs are positive and a short position when both are negative can generate an average abnormal return of 5.11 per cent per quarter.

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Notes

  1.  1 If no dividend is paid, stock return is the percentage change in price by definition.

  2.  2 Some zero earnings surprises are caused by rounding after stock splits. For instance, Stock A’s realized earnings per share is $1 and mean forecast of earnings per share is $0.99. Then the surprise is 1 cent. If Stock A has a 4-for-1 stock split, the realized earnings per share is $0.25 and mean forecast of earnings is $0.2475, which is rounded to $0.25 in the I/B/E/S database. Therefore, the earnings surprise after stock split is $0 because of rounding. We thank researchers at Wharton Research Data Services for kindly pointing this out to us.

  3.  3 We build two trading portfolios each quarter by following our ERE strategy and Brandt et al's (2008) EAAR and SUE two-way independent sort strategy, respectively. We then investigate how many stocks are in both portfolios at the same time.

  4.  4 This definition is the same as that used by the Wall Street Journal: online.wsj.com/mdc/public/page/2_3024-zurprise.html?mod=mdc_h_earnhl.

  5.  5 Many firms in a few trading days and a few firms in many trading days have missing return values, mainly due to missing prices or not trading on the current exchange. We replace the missing values with concurrent benchmark portfolio returns. However, to make EAARs calculation meaningful, we require that the total number of missing days be less than 10 per cent of the number of total trading days. For instance, to calculate 6-month (126 trading days) Drifts, if during this 6-month post-announcement period a firm have more than 13 missing return values, then the 6-month DRIFT of this firm for this quarter is excluded from our sample.

  6.  6 Both equal-weighted and value-weighted portfolio returns are calculated for each quintile. The results are similar.

  7.  7 We thank an anonymous referee for suggesting this.

  8.  8 See Johnson and Zhao (2012) for a detailed discussion.

  9.  9 Carhart (1997) reports that for open-end mutual funds from 1996 to 1993, the trading cost is 0.22 per cent for purchases and 0.63 per cent for sales.

  10. If we run a regression of our portfolio's excess returns on the market excess returns alone, the estimated beta is 0.0001. The S&P 500 Index is used as a proxy for the market portfolio in our regressions.

  11. Since all our explanatory variables are standardized, the interpretation of our results is slightly different. For instance, the coefficient on the ERE in Panel A, Table 3 is −0.22, indicating that if ERE increases by 1 SD, the 3-month DRIFT declines by 0.22 per cent.

  12. We thank an anonymous referee for suggesting this.

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Authors and Affiliations

  1. Department of Economics and Business, City College of New York, 160 Convent Ave, 10031, NY, USA

    Zhipeng Yan & Yan Zhao

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  1. Zhipeng Yan
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  2. Yan Zhao
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  3. Wei Xu
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  4. Lee-Young Cheng
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Correspondence to Yan Zhao.

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Yan, Z., Zhao, Y., Xu, W. et al. Earnings response elasticity and post-earnings-announcement drift. J Asset Manag 13, 287–305 (2012). https://doi.org/10.1057/jam.2012.8

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