Information Transfers from Management Earnings Forecasts: Irrational Underreaction and Subsequent Correction

Abstract

Prior literature has documented intra-industry information transfers from earnings announcements and management forecasts. The underlying cause of these observations is that a firm’s earnings announcements or forecasts contain information about earnings prospects of other firms in the same industry. While a majority of papers in this line of literature focuses on peer firms’ stock movements in response to the earnings reports or forecasts of the announcing or forecasting firms, respectively, we examine specifically whether investors’ reaction to information transfers from management earnings forecasts is rational. For nonforecasting firms, we find that investors consistently underreact to information transfers from peer firms’ management forecasts. Further, the underreaction is corrected when nonforecasting firms subsequently make earnings announcements. For late forecasting firms, the underreaction is only partly corrected when they release earnings forecasts subsequent to early forecasters, presumably due to the credibility concerns of management forecasts. The underreaction is further corrected when late forecasting firms later announce earnings. Finally, we partition forecast news based on whether the news implies industry commonalities or competitive shifts. We find evidence of underreaction to both the news containing industry commonalities and that containing competitive shifts.