The Post-earnings Announcement Drift
The alpha and omega of Quantitative Analysis
The birth of quantitative analysis in finance can be traced back to the groundbreaking work of Ray Ball and Philip Brown with "An empirical evaluation of accounting income numbers," published in the Journal of Accounting Research in 1968. In their seminal research, they unveiled a striking discovery, an anomaly that has withstood the test of time: the Post-earnings Announcement Drift (PEAD). This phenomenon suggests that stocks of companies that exceed earnings expectations tend to "drift" higher in the subsequent weeks and months following the earnings announcement, and vice versa for companies that miss expectations.
In their groundbreaking study, Ball and Brown laid the foundations for understanding earnings surprises through an innovative approach that primarily focused on deviations from a company's historical earnings trend. Their study relied on historical earnings data because, unlike today, there was no standardized method for predicting or articulating future earnings expectations.
After all, the first known securities analyst and the "father of value investing", Benjamin Graham, based his work on just such methods. However, after Ball and Brown's research, there emerged a bigger interest in securities analysts and earnings forecasts. Institutions like I/B/E/S (Institutional Brokers' Estimate System), founded in 1976, and First Call, founded in 1984, played a significant role in this. They started to collect, aggregate, and disseminate analysts' earnings forecasts to their clients, paving the way for the importance of consensus estimates in today's stock market.
With these new measures of earnings expectations came new ways of identifying earnings surprises. The impact of these developments on financial reporting was profound. With the rise of earnings surprise reporting, investors, analysts, and news outlets gained a powerful tool for understanding and predicting stock price movements. The earnings surprise became, and remains, a key focal point of earnings season coverage and a crucial driver of market activity.
Since the 1980s, numerous studies have been conducted exploring the Post-earnings Announcement Drift (PEAD) using analyst forecasts. In 1985, Bernard and Thomas explored the PEAD phenomenon in a series of studies and confirmed the anomaly using analysts' forecasts. Their work suggested that investors underreact to earnings news and that this underreaction leads to the observed drift. In 1990, Foster, Olsen, and Shevlin conducted a comprehensive study, incorporating analysts' forecasts and using a large sample of firms, confirming PEAD. Their findings implied that the market was inefficient in its initial reaction to earnings announcements and adjusted gradually over time, leading to a drift in stock prices.
Then came "Whisper Forecasts of Quarterly Earnings per Share" by Mark Bagnoli, Michael Beneish, and Susan G. Watts in the Journal of Accounting and Economics in 1999, identifying the validity and effectiveness of "whisper" forecasts, a type of earnings forecast that, unlike traditional analyst predictions, are largely informal and can vary greatly in source. They're often based on insider knowledge or compiled from estimates by various industry insiders and are not published in the typical ways that formal analyst forecasts are.
Bagnoli, Beneish, and Watts found that these whisper numbers provided a more accurate quarterly earnings per share (EPS) estimate than the consensus estimates produced by institutional analysts. They noted that the whisper forecasts were particularly useful in predicting extreme earnings, either significantly above or below the consensus forecast.
Furthermore, they found that the stock market's reaction to earnings surprises was more accurately predicted by the whisper numbers than by the I/B/E/S mean or median forecasts, providing evidence of the market's recognition of the superior information content in whisper forecasts. Their findings highlighted the valuable role of whisper forecasts in enhancing the understanding of earnings expectations and the market's reaction to earnings announcements.
You can read more about Earnings Whisper Numbers, but it's crucial to understand their origin and their increasing role in contemporary investment strategies. This approach's elevated precision, as well as the distinctive methodology behind the collection of the Earnings Whisper number, has led to its dominance in driving the Post-earnings Announcement Drift (PEAD) phenomenon since its inception in 1998.
From August 7, 1998, to the present, companies that exceeded the Earnings Whisper number experienced an average five-day gain of 0.6% from the opening price following the announcement. Conversely, stocks of companies falling short of the Earnings Whisper number dropped by an identical percentage. Interestingly, stocks of companies that failed to meet the Earnings Whisper, but managed to surpass the consensus estimate, also experienced a decline of 0.1% during the same five-day period.
Based on an analysis of 117,000 published Earnings Whisper numbers over the course of a quarter-century, the data underscores a critical shift in market behavior. The Post-earnings Announcement Drift, it appears, is no longer triggered by the surprises relative to consensus analysts' forecasts. Instead, the surprises against the Earnings Whisper number now steer this consistent market anomaly.
In conclusion, the evolution of quantitative analysis in finance has birthed a myriad of metrics and tools that have revolutionized our understanding of market dynamics. The Post-earnings Announcement Drift (PEAD) is a resilient testament to this evolution, from its inception, grounded in historical earnings data, to its current form, influenced by the refined measures of earnings expectations, notably the whisper numbers. Over the last 25 years, this whisper number, derived from a heterogeneous mixture of insider knowledge and industry estimates, has proven to be a more accurate predictor of quarterly earnings per share (EPS) and subsequent stock price movements than the traditional consensus forecasts. The Earnings Whisper number's superior information content has redirected the steering wheel of the PEAD phenomenon, illustrating a significant shift in market behavior.