Differential Market Reactions to Revenue and Expense Surprises

This study investigates investors’ reactions to surprises in revenues and expense reduction around the preliminary earnings announcements. The results of the study show that investors value more highly a dollar surprise in revenue than a dollar surprise due to a reduction of expenses, and that the breakdown into these two components adds information to market participants beyond the aggregate surprise in earnings. The study also shows that a dollar surprise in revenues is more valuable for growth firms than value firms, but that the difference between a dollar surprise in sales or expense reduction is smaller for value firms than for growth firms. Indeed, the study further documents that investors react positively when value firms announce negative sales surprises but positive surprises in expense reductions, but react negatively to such announcements by growth companies. This latter finding is shown to be related to cost cutting exercised by value firms that had negative sales surprises but positive earnings surprises. The study also shows that investors react more strongly to a surprise in sales the higher is the contribution margin ratio. In contrast, investors react more strongly to a surprise in expense reduction the higher is the ratio of expense persistence to sales persistence, and the higher is the proportion of operating expenses to total expenses. Finally, the study shows that market reactions also vary for companies that were able to meet analysts’ forecasts of earnings or beat them by one cent. Consistent with suspicions of expense management in such cases, companies with positive (negative) sales surprises are associated with positive (negative) market reactions. The combined results of this study indicate the importance of interpreting the earnings surprise in the context of its sources – whether it is due to the surprise in revenues or the surprise in total expenses. Differential Market Reactions to Revenue and Expense Surprises A wide body of research documents a positive association between unexpected earnings and market reactions around the preliminary announcements of earnings (see Lev, 1989 and Kothari, 2001 for reviews of prior studies). However, substantially less research has been directed to the problem of assessing whether investors react differently to a dollar surprise in revenues than to a dollar surprise in expenses, and whether value and growth companies experience differential reactions to the sales and expense surprises. Since firms announce both revenues and earnings in the preliminary earnings announcement, investors can use the disclosure of revenues to better assess and interpret the quality of the disclosed earnings signal. The purpose of this study is to shed light on the differential market reactions to revenue and expense surprises in various contexts. Most valuation models suggest that investors react more strongly to any surprise that is more persistent or less noisy. To the extent that the revenue surprise is more persistent and/or less noisy than the expense reduction surprise, investors are expected to react more strongly to the revenue surprise than to the expense surprise. We provide below evidence that the revenue surprise is more persistent, and surmise that the expense 1 Throughout the paper, the term “expenses” refers to the difference between sales and earnings, where earnings is income before extraordinary items. 2 In recent years, some firms have begun disclosing more income statement items in their preliminary earnings announcements, as well as pro-forma earnings, which are supposed to convey information about recurring earnings. These additional disclosures may further help investors assess the quality of earnings, beyond the disclosure of revenues and earnings alone. However, this study covers earnings announcements since 1994 for a large sample of firms, many of which did not provide detailed disclosures of expenses, or a breakdown of recurring and non-recurring items in their announcements. To the extent that more information about expenses was available in the preliminary earnings announcement beyond that of revenues, the results of this study will be biased against finding significant differential reactions to revenue and expense surprises.