ACCOUNTING EARNINGS AND STOCK PRICES
Information Content of Earnings
• Distinguish between:
– Earnings reflecting factors that affect stock
prices
– Earnings announcements conveying
information to the stock market
• To test this hypothesis: observe the stock price
change at the time the earnings are
announced.
Information Content of Earnings (Cont’d)
• There are many alternative sources of
information on a firm’s cash flows that
can reduce the information content of
earnings announcement
Sign of Unexpected Earnings and Mean
Abnormal Returns
• Ball and Brown (1968):
– Investigates the relation between the sign
of unexpected earnings and mean
abnormal rates of return
• Other studies of annual earnings
– BB study has been replicated for annual
earnings announcements by firms traded in
U.S. markets other than the NYSE and for
firms traded in other countries  results
are not unique to the NYSE.
Sign of Unexpected Earnings and Mean
Abnormal Returns
• Other studies of annual earnings
– Braun (1970):
• Australian companies.
• Differences: price adjustment during the year is
less rapid on Australian Exchanges than on
NYSE and there is more price adjustment in the
announcement month on the Australian
Exchanges.
– Australian companies issue semiannual instead of
quarterly reports
– Australian firms are, on average, much smaller than
NYSE firms
Sign of Unexpected Earnings and Mean
Abnormal Returns (Cont’d)
• Interim earnings
– Creates some problems in interpreting Ball
& Brown’s results:
• Interim reports could be responsible for some
of the stock price adjustment to annual
earnings that occur in the year before the
annual earnings announcements.
• Information content of the earnings
announcements could be
understated/overstated.
Sign of Unexpected Earnings and Mean
Abnormal Returns (Cont’d)
• Interim earnings
– Foster (1977):
• The evidence is consistent with the hypothesis
that quarterly earnings reflect factors
impounded in stock prices and quarterly
earnings convey information to the capital
market.
Magnitude of Unexpected Earnings and Mean
Abnormal Returns
• Beaver, Clarke, and Wright (1979)
– Investigate the magnitude
– There is a relation between the magnitude
of the unexpected earnings change and
the abnormal rate of return.
• Beaver, Lambert, and Morse (1980)
– Consistent result
Earnings Announcements and
Variance of Abnormal Returns
• Beaver (1968a)
– To avoid specifying a model for expected earnings
– Average abnormal return variance is larger in the
week of announcement of annual earnings.
• Other Variance Studies
– May (1971): American Stock Exchange (ASE)
– Hagerman (1971): OTC market
 Both results are similar to Beaver’s
Earnings Announcements and
Implicit Return Variances
• Patell & Wolfson (1979, 1981): use call
option prices to test whether the market
anticipates the variance increase at the
time of earnings announcements.
– The evidence is consistent with the market
anticipating the release of the information
in earnings announcements.
Earnings Announcements and Trading Volume
• Beaver (1968a): also investigates
changes in the volume of trading
associated with earnings
announcements.
– Results: large increase in volume in the
earnings announcement week
 Earnings announcements convey
information to the stock market
Earnings and Cash Flows
• Several studies (Ball & Brown (1968), Beaver
& Dukes (1972)) find that current cash flows
are less highly associated with abnormal
returns.
• Patell & Kaplan (1977): cash flows do not
have marginal information content.
• It should be noted: none of those studies
actually uses operating cash flows.
• It would be interesting to use total net cash
flows instead of operating cash flows
Variation in Information Content
• Grant (1980)
– The information content of earnings
announcements varies with the number of
alternative source of information.
• McNichols & Manegold (1983)
– Reduction in the relative information
content of annual earnings announcements
following the introduction of quarterly
reporting.