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Are earnings predictable?

Evidence from equity issues and buyback announcements

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Abstract

We find that market reactions to earnings announcements can be predictable. Four-factor abnormal returns to earnings announcements that follow buyback announcements are higher by 5.1% than similar returns to earnings announcements that follow equity issues over the (− 1,+ 30) window; the difference is 2.2% when unadjusted returns are used. The magnitude is large and economically and statistically significant. The drift in these returns is unrelated and distinct from the post-earnings announcement drift. For example, we find positive drift for firms making buyback announcements even when they exhibit negative earnings surprises and find negative drift for firms issuing equity even when they show positive earnings surprises. Since the study looks at short periods around earnings announcements, it does not suffer from benchmarking errors that may influence long-horizon returns.

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Notes

  1. These events include open market buybacks (Ikenberry et al. 1995), seasoned equity offerings (Spiess and Affleck-Graves 1995), initial public offerings (Ritter 1991), dividend initiations and omissions (Michaely et al. 1995), stock splits (Ikenberry et al. 1996), mergers (Agrawal et al. 1992), spinoffs (Cusatis et al. 1993), tender offers (Lakonishok and Vermaelen 1990), and short interest announcements (Boehmer et al. 2010).

  2. Several recent studies show serious limitations of long-term return studies including the choice of benchmark models and matching algorithms. Kothari and Warner (2007) and Kothari and Warner (1997) show that tests for multi-year abnormal performance around firm-specific events are severely misspecified and the lack of a perfect benchmark model of normal returns over horizons considered in long-term studies does not permit for reliable inferences.

  3. For example, the studies of Taggart (1977), Marsh (1982), Asquith and Mullins (1986), Korajczyk et al. (1991), Loughran et al. (1994), Jung et al. (1996), Pagano et al. (1998), Hovakimian et al. (2001), and Eckbo et al. (2007) show that the seasoned equity issues and initial public equity issues coincide with high valuations. Buybacks, on the other hand, coincide with low valuation, as shown in Ikenberry et al. (1995). Studies of long-run stock returns following corporate finance decisions show firms issue equity when the cost of equity is relatively low and repurchase equity when the cost is relatively high. See Stigler (1964), Ritter (1991), Loughran and Ritter (1995), Spiess and Affleck-Graves (1995), Brav and Gompers (1997), and Jegadeesh (2000) for more details. Studies of earning forecasts and realizations around equity issues show that firms tend to issue equity when investors are too enthusiastic about earnings prospects. Loughran and Ritter (1997), Rajan and Servaes (1997), Teoh et al. (1998b), Teoh et al. (1998a), and Denis and Sarin (2001) are some sample studies in this category.

  4. The difference between raw and abnormal returns is unusually high for SEO issues. We reestimate abnormal returns using different platforms including Eventus, STATA, and SAS, and test a few observations with Excel, all of which confirm these results. We also test the abnormal returns using a three-factor model and a one-factor model. Using alternate periods for parameters estimation does not significantly alter the results. It seems that much of the four-factor adjustment arises from high values of systematic risk of firms issuing equity.

  5. In examining the nature of information conveyed by open-market buyback announcements, Bartov (1991) analyzes the surprise in actual earnings announcements relative to consensus forecasts but finds weak results. Instead, we focus on the market reaction to earnings announcements. We believe that the market’s reaction to earnings announcement is a more appropriate tool than analyst forecasts to test our hypotheses because analyst forecasts have to be corrected for biases and those corrections themselves are likely to introduce new biases generating mixed results (Lim 2001; Hong and Kubik 2003).

  6. Several studies show that the long-term return methodologies are sensitive to the choice of benchmark. For example, Fama (1998) argues that most long-term return anomalies tend to disappear with reasonable changes in technique. Similarly, Kothari and Warner (1997), Barber and Lyon (1997), and Lyon et al. (1999) show that using wrong benchmarks in measuring long-term abnormal returns would lead to erroneous inference on the significance of the event of interest.

  7. All market capitalizations are in 2013 dollars, based on the All Urban Consumers (CPI-U) index from the U.S. Department of Labor, Bureau of Labor Statistics.

  8. We test the results with other windows. For example, we consider firms where the announcement of buybacks or SEO pricings occurs 6 to 15 days or 6 to 30 days before earnings and estimate the earnings announcement returns. The findings are consistent with the main results discussed in this section.

  9. In untabulated results, we also calculate the returns around the announcement of earnings for firms that announce a buyback program after earnings. We document significantly negative returns around the earnings announcement date. This finding implies that buybacks announced after an earnings announcement usually follow poor earnings.

  10. In untabulated results, we also calculate the returns around the announcement of earnings for firms that price an SEO after earnings. We document significantly positive returns around the earnings announcement date. This finding implies that SEOs priced after an earnings announcement usually follow good earnings.

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Authors and Affiliations

  1. Finance Department, Daniels College of Business, University of Denver, Denver, CO, USA

    Shahram Amini

  2. Finance Department, Pamplin College of Business, Virginia Tech, Blacksburg, VA, USA

    Vijay Singal

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  1. Shahram Amini
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Correspondence to Shahram Amini.

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We thank Honghui Chen, Murali Jagannathan, Greg Kadlec, Raman Kumar, John Easterwood, and seminar participants at the 2017 Financial Management Association, Virginia Tech, and University of Denver for helpful comments. All errors are ours.

Appendix

Appendix

Table 10 Summary statistics for repurchasing and issuing firms
Full size table
Table 11 Distribution of buybacks and SEOs
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Amini, S., Singal, V. Are earnings predictable?. J Econ Finan 44, 528–562 (2020). https://doi.org/10.1007/s12197-019-09499-z

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