An Empirical Evaluation of the Adjustment of Stock Prices To New Quarterly Earnings Information, Journal of Financial and Quantitative Analysis by Ronald, J. Jordan (1973)
The study focuses on earnings as a key
variable in evaluating the firm's share price. If these theories are correct (namely, that earnings are important in
determining the value of a firm), then it is a logical extension of this train
of thought to hypothesize that at some point in time this earnings information
should be reflected in stock price movements. The tests conducted on this
Journal Article work were meant to evaluate the speed of price adjustments to
various kinds of information, also one could easily argue that these forms of
measurement are too broad for this rather delicate operation. However the
objective of the study is to explore the adjustment process of stock prices to
new quarterly earnings information.
That is the effect of earnings reports on
changes in expectations as reflected in share price movements. The primary conclusions of this study are:
That the market evaluates third quarter and annual earnings differentially from
first and second quarter earnings, and That share prices of growth companies
adjust differentially from the share prices of non-growth companies, a result
anticipated from the simple evaluation model E /(r-g).
METHODOLGY
This sample consists of 45 firms chosen randomly
from Forbes' 21st Annual Report on American industry. The statistic
of interest in this report is the five-year annual increase in per-share
earnings in percent.1 From this population three stratified samples of 15 firms
each according to its five-year annual compounded growth rates were selected.
These subsamples comprise firms with increasing earnings (Group I), decreasing
earnings (Group II), and stable earnings (Group III). The period covered by
this study is April 1, 1963 - December 31, 1968. It’s selected because it was
the first complete year for which daily price data were available on the ISL
tapes, and the latter date chosen because the American Institute of Certified
Public Accountants changed reporting standards regarding earnings per share
figures effective for fiscal years beginning after December 31, 1968. However,
King has found that a substantial influence on stock prices is brought about by
market-wide factors, it becomes necessary to abstract from general market
conditions before attempting to examine the adjustment of stock prices to new
quarterly earnings information. The model for achieving this goal was first
suggested by Markowitz and later further developed by Sharpe, and Lintner.
Inasmuch as all "omitted" variables have by construction been
impounded in the error term "u," it should be apparent that a
quarterly earnings announcement will have an impact on a security's rate of
return in the days surrounding that announcement and, consequently, will have
an impact on the behavior of that security's regression residuals during the
affected period. Thus, a major part of the paper will be concerned with an
analysis of this abnormal residual behavior and its various implications. This
residual behavior will be examined through both the mean residuals and the
absolute mean of residuals surrounding the quarterly earnings announcements.
The mean of the residuals captures all the impact on a firm's share price on a
given day relative to earnings announcements which cannot be
"explained" by the market index relative. Since the absolute mean of
the residuals disregards signs and looks only at the numerical value of the
residual, it measures uncertainty. Essentially, the absolute mean captures the
same information as does the mean with the absence at least in part of one item
random noise. After initial testing and analysis of the data, the 50-day period
surrounding earnings announcements (25 days preceding the announcements to 24
days following the announcements) was selected as the appropriate time period
for the two-way Analysis of Variance Tests in this study.
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