Post-Earnings-Announcement Drift: The Role of Revenue Surprises

Consistent with prior evidence about greater persistence of revenues and greater noise caused by heterogeneity of expenses, this study shows that the post-earningsannouncement-drift is stronger when the revenue surprise is in the same direction as the earnings surprise. The results of the study are consistent for the earnings and revenue surprise estimated from historical time series and also from analyst forecasts. The results of this study are also robust to various controls, including the proportions of stock held by institutional investors, trading liquidity, and arbitrage risk. Post-Earnings-Announcement Drift: The Role of Revenue Surprises One of the most puzzling market anomalies is the post-earnings-announcement drift (henceforth drift), where stock prices continue to move in the direction of the earnings surprise up to a year after the earnings is publicly known. The academic literature offers three major explanations for this phenomenon; (a) shifts in risks of firms with extreme surprises, justifying higher expected returns in equilibrium, (b) methodological problems in previous studies that document a phenomenon that does not exist in reality, and (c) investors’ under-reaction to the earnings signal during the announcement period, which are subsequently corrected due to new information, delayed processing of the previously-released information, or a combination of the two. Recent research of the drift investigates factors that are associated with different drift levels according to prior intuition about the effects of these factors on investors’ under-reaction. For example, Bartov et al (2000) show that the drift is lower for companies with higher proportions of institutional investors, who are more sophisticated and less prone to under-reactions. Mikhail et al (2003) provide evidence that the drift is smaller when companies are followed by more experienced analysts, who tend to incorporate the earnings surprise more fully in their forecasts and reduce the underreaction typically observed for less experienced analysts. Mendenhall (2003) shows that the drift is stronger for firms subject to higher arbitrage risks, consistent with market equilibrium of investors who initially under-react to earnings announcements, and A reversal typically occurs upon the announcement of same-quarter earnings in the following year. arbitragers who are unwilling to completely eliminate the under-reaction effects on prices due to greater arbitrage costs. The purpose of this study is to investigate the role of revenue surprises in predicting differential drift levels, presumably due to the association of the revenue surprise with future earnings surprises. Ertimur et al (2003) show that short-window market reactions to revenue surprises are stronger than those of expense surprises, due to the greater persistence of revenue surprises and the greater heterogeneity of expenses. Thus, when the sales surprise is in the same direction as the earnings surprise, the earnings surprise is more likely to persist in future periods and a greater drift in prices is expected when investors obtain future information confirming the initial earnings surprise. In contrast, when the earnings surprise is mostly driven by an expense surprise (i.e., when the earnings and sales surprises are conflicting), the under-reaction may not manifest itself in a strong future drift, because future information is less likely to confirm the original earnings surprise. The results of this study show that the earnings drift is stronger when the earnings surprise is in the same direction as the sales surprise. These results continue to hold even after controlling for the sophistication of investors (proportion of institutional holding), trading liquidity and arbitrage risk. These results are robust in different sub-periods, including the more recent period (1998-2002), which spans extreme market increases and decreases. The results are also robust in three different samples; a large sample of firms with a wide dispersion of market capitalization, a sub-sample of firms that are followed 2 In their study, as in this study, the term expenses includes all items between sales and net income before extraordinary items, consisting of operating expenses, financial expenses, gains or losses on disposition of long-term assets, and non-recurring items.