March 2005, Chiba Marine Stadium,giving advice to Bobby V.

Does Earnings Guidance Affect MarketReturns? The Nature and Information
Content of Aggregate Earnings Guidance
Carol Anilowski
Mei Feng
Douglas J. Skinner

February 2006

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“Having Mo’” Ahead of the Tape,
WSJ, C1, January 6, 2004

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Research Question“The earnings preannouncement season starts kicking into gear thisweek. Fortunately for investors, they have little to worry about whenit comes to fourth-quarter earnings or warnings…
Preannouncements so far have been mild, with a low ratio ofnegative to positive earnings previews. According to Thomson First
Call, the ratio stands at 1.3, a low rate because negative warnings
almost always outpace positive preannouncements...”Two key points. Guidance is assumed to: Does aggregate earnings guidance provide information to themarket as a whole?
– We know from much prior research that earnings guidance,especially downward guidance about quarterly earnings, isinformative at the firm level.
– It also seems that earnings guidance has become increasingly
common, and is no longer something that companies do only onoccasion.
– If guidance is now pervasive, can we aggregate in any
meaningful way?

1. Be informative about earnings in general, and
2. Preempt much of the earnings news.

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Why might guidance affectmarket-level returns?

Does guidance convey information
about economy-wide cash flow shocks?

Stock returns are affected by (e.g., see Fama, 1990):
1.

Shocks to expected cash flows,2.

Predictable variation in expected returns,

3.

Shocks to expected returns.

4 Pervasiveness: The larger the number of firms that issue guidance,
the more likely it is that aggregate guidance captures market-wide
cash flow news.
– It may not take many firms if these firms are very large (GE,Microsoft) given an increasingly skewed size distribution.
 Representativeness:– It may not take many firms if these firms are “bellwethers” (arethere firms whose earnings are sufficient statistics for theeconomy?).

Whether guidance conveys information about aggregate
cash flow shocks depends on:–

Whether it’s pervasive.

–

Whether it’s representative.

–

Whether it’s timely.

– On the other hand, previous research shows that guidance tends
to be issued by firms with unusual or surprising earnings
performance (e.g., Lev and Penman, 1990; Skinner, 1994).
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Does guidance convey information
about economy-wide cash flow shocks?

Will guidance affect market-level
expected returns?
1.

– Recent evidence in finance suggests that firm-level earnings
news is largely idiosyncratic, and diversifies away uponaggregation.
– It is not settled whether firm-level earnings news is largely
idiosyncratic or contains systematic components.

This implies that good earnings news signals an improvement ineconomic conditions, which lowers required returns on stocks andcauses stock prices to increase.

 Timeliness: Earnings guidance will not be informative if it’s fully
anticipated. By definition though, earnings guidance is more timely
than normal quarterly earnings releases.

Alternatively, good earnings news could signal an improvement inaggregate demand, increasing inflationary expectations whichincreases (nominal) required returns on stocks. Kothari, Lewellenand Warner (2005) find that aggregate quarterly earnings news isnegatively related to quarterly returns.

– Does the nature of the guidance affect when it’s released?
Previous research suggests that managers tend to release more“bad news” forecasts than “good news” forecasts, especially forthe quarterly horizon (Skinner, 1994). Does the market “build
this in” (that is, look at the relative extent of bad news)?
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Will guidance affect market-level
expected returns?
2.

It is well known that macroeconomic news is positively related tocurrent earnings news (e.g., Lucas, 1977) and negatively related tocurrent expected returns (e.g., Fama and French, 1989; Cochrane,1991).

Note: Researchers in finance (e.g., Chen, Roll, and Ross, 1986)
have had a surprisingly difficult time establishing a relation between
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macroeconomic variables and stock returns.

We know relatively little about the effectsof earnings news at the aggregate level

Earnings guidance may affect levels of market uncertainty. If, forinstance, guidance increases market uncertainty, this will increase
the volatility of market returns. Since volatility shocks arepersistent, this will increase expected returns and push stock prices
down.

 Penman (1987). Documents seasonal patterns in aggregate
earnings news (firms tend to announce good earnings news in thefirst two weeks of calendar quarters 2, 3, and 4) and that there arecorresponding patterns in market returns.
 Kothari, Lewellen, and Warner (2005). Find that quarterly market
returns are negatively related to measures of aggregate quarterly
earnings news. The authors argue that this result suggests that
aggregate earnings news is positively related to expected returns,
so that good earnings news pushes stock prices down.

Anecdotally, a spate of earnings warnings from technology
companies in the summer of 2004 increased market uncertainty
and caused stock prices to decline; see “Investor Jitters Greet
Earnings Season,” Financial Times, July 12, 2004.
“Volatility feedback” – if earnings news increases uncertainty andso required returns on stocks, it will tend to reduce the positive
response to good earnings news and exaggerate the negative
response to bad news, causing asymmetries in the market’s
response to good and bad news (e.g., Skinner and Sloan, 2002).
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What we find: On guidance

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What we find: On guidance Guidance is increasingly pervasive and representative.

 There are clear patterns in the timing of guidance:– The extent of earnings guidance increases substantially over thesample period (1994-2003).
– Firms issuing guidance now represent over one-half of total
market cap and nearly one-half of total assets, up from levels of
10%-20% in the mid-1990s.
– Guidance is now driven more by firm characteristics such as sizeand growth, and is less attributable to period-specific earningsperformance. Prior forecasting is increasingly important.
 Similar to previous research, the distribution of earnings guidance istilted toward shorter-term forecasts of adverse earnings news, whichis also the most informative.

– Managers tend to issue neutral guidance early in the quarter,
negative guidance late in the quarter, and positive guidance only
after the end of the quarter.
– The information content of earnings guidance increases steadily
during the quarter.
 There is a good deal of quarter-to-quarter variation in the relativeextent of downward quarterly guidance (ratio of the amount ofdownward to upward guidance), reinforcing the idea that this ratio
may capture variation in overall earnings news. There is much lessvariation using annual guidance numbers.

 An increasing tendency for guidance to be issued at earnings
announcement dates.
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What we find: On the informativenessof guidance

What we find: On the informativenessof guidance Quarterly guidance measures, esp. the relative extent of quarterly
negative guidance, are strongly associated with measures ofaggregate earnings news such as analyst forecast- and time seriesbased measures.

 Guidance issued by very large firms is associated with market
returns in narrow windows around its release, further supporting theidea that guidance is informative at the market level.

 There is no evidence that these quarterly guidance measures arecorrelated with market returns.
 Some evidence that guidance is related to market returns when weuse monthly data. But direction of causality harder to establish –does macro news cause changes in guidance and returns, or doesguidance lead returns?
 There are clear differences in the pattern of market returns during
good and bad news quarters – market returns increase smoothly
during good news quarters but decline in bad news quarters only
during the last month of the fiscal period. Market volatility is
noticeably higher in bad news quarters.

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Summary of Findings Over the past decade, earnings guidance for US firms has become
increasingly pervasive – now provided by around 30% of Compustat
firms by number and over 50% by value. Moreover, firms are now
providing guidance on a more routine basis (often at earnings
announcements), so that guidance has become more representative.
 Find strong evidence that negative guidance is more informative
than other guidance at the firm level, and that the relative amount ofquarterly downward guidance available does a good job of capturing
the quarter’s overall earnings news.
 However, the evidence that aggregate guidance measures drive
market returns is not as strong. Hard to be sure that it is not
macroeconomic news that drives both guidance and returns. Still,
we find some evidence that certain types of guidance, especiallynegative guidance issued near the end of the quarter, is informativefor overall returns, but only in bad news quarters.
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