A company has had a good year, and wants to make sure investors know it. So the headline of its press release announces, “Earnings Per Share up 16.5%” — which, the release reports, is a record.
What could be more natural for a company to do than highlight impressive earnings?
But, according to new research, it’s also a reason for investors to be wary. “Headlining quantitative information incites investor overreaction,” says a study in the American Accounting Association journal The Accounting Review. “At the time of earnings announcements, investors do not fully appreciate managers’ opportunistic incentive to highlight temporary good performance.”
Formats of earnings-release headlines vary widely across companies, note the paper’s authors, Xuan Huang of California State University Long Beach, Alex Nekrasov of the University of Illinois at Chicago, and Siew Hong Teoh of the University of California, Irvine.
Some companies, they explain, disclose only generic text in headlines, simply stating that the firm is announcing its financial results. Others headline some results, such as earnings or revenue, directionally without providing actual numbers. Still others (like the company cited above) headline actual numbers.
About 28% of more than 17,000 studied earnings releases specified performance numbers in their headlines, a practice the professors characterize as increasing the salience of the results.
They found that increasing headline salience (for example, when earnings exceed forecasts, headlining by how much) gives a hefty lift to a firm’s stock price beyond the rise normally occasioned by good news. On average, adding one strong performance number to a headline increases a results-inspired boost by an extra one third in the three-day period around the announcement.
But after that quick stock-price lift, salience typically portends a considerable reversal over the 60 days following the earnings announcement — a reversal greater than the initial boost that the salience bestowed.
“An initial favorable impression can lead investors to underweight contradictory information elsewhere in the report,” the paper states.
Headline salience also foreshadows even longer-term disappointments. Companies that flaunt strong current results in earnings-release headlines have lower “earnings persistence.” That suggests managers are motivated more by opportunism than a desire to make disclosure generally more informative.
Further, salience decisions are likely to coincide all too conveniently with the personal financial interests of top executives. High salience, the study finds, is strongly associated with increased insider stock sales in the month following earnings announcements and also with the recent vesting of executives’ stock.
Conversely, when there is personal financial benefit in stock-price decline — namely, when an earnings announcement precedes a grant of stock options — managers, are less likely to use salience, the research found.
The study findings derive from an analysis of annual earnings press releases issued over an 11-year period. Salience was calculated as the number of performance statistics appearing in headlines. In about 72.1% of the releases, there were none; in 11.9%, there was one; and in 8.5% there were two, in 2.9% three, and in the remaining 4.5% more than three.
Among accounting terms appearing in headlines, the greatest number were earnings-related, followed by those related to revenue. Companies’ earnings persistence was calculated by whether gains achieved from one year to the next were equaled or exceeded in a third year. Analyses controlled for an array of factors that can affect stock price or company performance.
Other research findings include the following:
■ Both 3-day stock returns and 60-day reversals increase as the number of headline statistics increases.
■ While headline salience is effective when earnings exceed analyst forecasts, that is not the case when earnings barely meet or fall short of predictions.
■ Headlined earnings numbers have more effect when expressed as percentages than when stated in dollars.
In conclusion, the professors write, the findings about headline salience, combined with recent evidence on the tone of qualitative text and managers’ verbal communications, “raise the question of whether accounting and financial regulators need to consider the broader character of firm communications to protect investors.”
The study, “Headline Salience, Managerial Opportunism, and Over- and Underreaction to Earnings,” will be in the November issue of The Accounting Review.