ABSTRACT

This study provides a theoretical rationale and empirical support that relates the existence and magnitude of the premium for meeting/beating analysts' EPS forecasts to the existence of preannouncement price momentum. The study is based on the theoretical work that suggests that extreme levels of price momentum can cause security prices to deviate from fundamental values even in the presence of well-informed and well-financed rational arbitrageurs. Differences of opinion regarding the extent of mispricing and/or optimal exit time to exit the position allow this mispricing to persist (Abreu and Brunnermeir 2002, 2003). To correct mispricing, a news event, like an earnings announcement, is necessary to synchronize investors' exit strategy beliefs (Abreu and Brunnermeir 2002, 2003). In the case of an earnings announcement, this synchronization of beliefs triggers a price reaction of such magnitude that it cannot be explained by unexpected earnings. Instead, we hypothesize and show that the abnormal price reaction is largely captured in what empirical researchers have identified as the meet/beat market premium. Our findings provide a cohesive argument for the temporal variation in meet/beat premiums documented by Koh, Matsumoto and Rajgopal (2008).

 Conclusion

Prior research has documented the existence of a stock return premium for meeting or beating analyst forecasts of earnings even after controlling for unexpected earnings. Despite the empirical evidence of its existence, the basis of the meet/beat premium has remained a somewhat unexplained phenomenon in the literature. Evidence in the paper demonstrates that the meet/beat premium is strongly related to the degree of pre-announcement stock price momentum. We attribute this relation to pre-announcement momentum being linked to disagreement among investors concerning the extent of mispricing in a security and/or the optimal exit strategy from the security. The meet/ beat signal in the earnings announcement serves to synchronize investor beliefs concerning the extent of mispricing and either validates the current price path or triggers a correction. We posit that the differential return observed in the two outcomes is what has been defined in the literature as the meet/beat premium. The findings of this study have broad implications for future research on the usefulness of accounting information in security valuation. Traditionally, the usefulness of accounting information has been considered primarily from the standpoint of fundamental analysis. This study demonstrates that accounting information may also be useful in correcting anomalous market conditions.