Why do analysts revise their stock recommendations after …

Why do analysts revise their stock recommendations after earnings announcements?

Ari Yezegel Assistant Professor of Accounting

Bentley University 175 Forest Street Waltham, Massachusetts 02452 ayezegel@bentley.edu Tel: +1.781.891.2264 Fax: +1.781.891.2896

Abstract During earnings announcements, managers disclose a variety of information that leads to changes in expectations of future earnings and share prices. To the extent that share prices fully reflect new information, earnings announcements are not expected to create opportunities for market participants to detect mispricing. However, analysts often advise their clients to trade in response to earnings announcements. Nearly a quarter of all analysts' recommendation revisions occur within the three-day period after earnings are announced. This paper examines why such a large fraction of recommendation revisions are concentrated after earnings announcements. The empirical analyses suggest that recommendation revisions are more concentrated after earnings announcements when there is greater mispricing and when it is harder for analysts to obtain information from alternative sources. In addition, recommendation revisions are more concentrated after earnings announcements for firms with more complex information and informative earnings. Further, examination of how analysts revise their stock recommendations using earnings information shows that analysts revise their recommendations in the direction of the earnings surprise measured based on their own and consensus estimates. However, analysts give more weight to consensus expectations than their own forecasts. Also, analysts appear to assign less weight to earnings surprises when consensus expectations are likely to have been achieved through expectation management and when the earnings information confirms analysts' prior opinions. Finally, earnings announcements coupled with recommendation revisions exhibit higher earnings response coefficients consistent with a more efficient pricing of earnings information.

Keywords: financial analysts, stock recommendations, earnings announcements, information interpretation versus information discovery.

JEL: M41; G24; G14.

Why do analysts revise their stock recommendations after earnings announcements?

Abstract During earnings announcements, managers disclose a variety of information that leads to changes in expectations of future earnings and share prices. To the extent that share prices fully reflect new information, earnings announcements are not expected to create opportunities for market participants to detect mispricing. However, analysts often advise their clients to trade in response to earnings announcements. Nearly a quarter of all analysts' recommendation revisions occur within the three-day period after earnings are announced. This paper examines why such a large fraction of recommendation revisions are concentrated after earnings announcements. The empirical analyses suggest that recommendation revisions are more concentrated after earnings announcements when there is greater mispricing and when it is harder for analysts to obtain information from alternative sources. In addition, recommendation revisions are more concentrated after earnings announcements for firms with more complex information and informative earnings. Further, examination of how analysts revise their stock recommendations using earnings information shows that analysts revise their recommendations in the direction of the earnings surprise measured based on their own and consensus estimates. However, analysts give more weight to consensus expectations than their own forecasts. Also, analysts appear to assign less weight to earnings surprises when consensus expectations are likely to have been achieved through expectation management and when the earnings information confirms analysts' prior opinions. Finally, earnings announcements coupled with recommendation revisions exhibit higher earnings response coefficients consistent with a more efficient pricing of earnings information. Keywords: financial analysts, stock recommendations, earnings announcements, information interpretation versus information discovery. JEL: M41; G24; G14.

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1. Introduction Nearly a quarter of all financial analysts' recommendation revisions take place within the three-day period following earnings announcements. The concentration of recommendation revisions is puzzling given that earnings announcements are public disclosures. Efficient market hypothesis posits that it is not possible for investors to earn abnormal profits by trading in response to earnings announcements because public information is instantaneously incorporated into share prices. However, analysts frequently advise their clients to trade based on information conveyed in earnings announcements.

Presumably, analysts issue recommendations based on a comparison of their own valuation with the market's valuation. When analysts' valuation is significantly greater than the market's valuation, analysts are expected to issue favorable recommendations and when it is significantly less, they are expected to issue unfavorable recommendations. A significant change in an analyst's valuation, due to new public information (e.g. earnings announcements) is not necessarily expected to warrant a stock recommendation revision because the new information is likely to have already been incorporated into market prices. Therefore the new information is not expected to affect analysts' value-to-price comparison. Nevertheless, 23.1 percent of recommendation revisions are concentrated shortly after earnings announcements (trading days 0, 1 and 2).

This paper examines why and how analysts revise their recommendation ratings in response to earnings announcements and whether recommendation revisions contribute to the pricing of earnings. Examining these research questions aims to improve our understanding of the informational and firmspecific characteristics that induce analysts to issue new recommendations based on public information. Accordingly, the findings of this paper shed light on the factors that contribute to analysts' ability to process public information in a manner that produces private information. In addition, examining how analysts respond to earnings announcements in the form of recommendation revisions intends to improve our understanding of how sell-side analysts use accounting information in their valuations to

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revise their recommendations and give advice to their clients. Finally, the investigation of the relation between analysts' recommendations following earnings announcements and the pricing of earnings aims to expand our knowledge of the role that analysts play in facilitating market efficiency.

In order to determine why analysts revise their recommendations after earnings announcements, I measure the concentration of recommendation revisions after earnings announcements at a firm-quarter level and explore factors that contribute to the variation in the concentration. Prior evidence on the post-earnings announcement drift suggests that investors fail to fully incorporate earnings information into prices (Ball and Brown 1968, Bernard and Thomas 1989 and Livnat and Mendenhall 2006). Therefore, it is possible that financial analysts use public information released in earnings announcements to make informed recommendation revisions. Conversely, analysts may be strategically revising their recommendations to improve the perceived profitability of their recommendations. In addition, financial analysts are sophisticated market participants trained and specialized in understanding the operations of the companies that they cover. Even though earnings disclosures are made available to the general public, it may be difficult for ordinary investors to interpret and process these disclosures. This effect is likely to be more pronounced for firms with complex information. For these firms, analysts may be able to apply their superior information processing skills to produce private information based on earnings disclosures. Further, analysts who follow companies with less information availability are more likely to rely on earnings announcements to issue recommendations because they have fewer sources of information. Therefore, the scarcity of public information may lead to the concentration of recommendation revisions after earnings announcements. Finally, analysts are more likely to revise their recommendations after earnings announcements issued by firms with more informative earnings. Since the key driver of stock recommendations is the valuation of the company, information signals that have stronger implications for valuation are more likely to be

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associated with changes in recommendation ratings. This study examines the extent to which the factors above influence the concentration of recommendation revisions after earnings announcements.

As the second objective, this paper examines how analysts use earnings information to revise their recommendations. The examination of how analysts use earnings information calls for an analystfirm-quarter level analysis. Upon receiving earnings information, analysts can either compare the reported earnings to the consensus expectation or to their own earnings forecasts. To the extent that analysts rely more on their own forecasts to develop valuations and issue recommendations, a stronger relation between recommendation revisions and earnings surprises based on their own forecast is expected. In contrast, if analysts rely more on the consensus expectations to estimate their valuation models, we expect analysts' recommendation revisions to be more strongly correlated with the earnings surprise measure based on the consensus expectation. Bartov et al. (2002) and Matsumoto (2002) show that managers, at times, avoid negative earnings surprises by managing analysts' earnings expectations downwards. While downward expectation management can help firms achieve earnings targets, it also reduces the quality of earnings surprises because targets are achieved in part by lowering expectations. I examine whether analysts recognize expectation management activities and place less weight on earnings surprises when there is a greater probability of expectation management. Further, Altinkilic and Hansen (2009) propose strategic timing of revisions to enhance perceived stock picking performance as an explanation for the concentration of recommendations after news. They carry out various tests to rule out alternative explanations. This paper conducts a direct test of the explanation proposed in Altinkilic and Hansen (2009) by examining whether the association between analysts' recommendation revisions and earnings surprises is stronger for analysts' with poorer past stock picking performance. If analysts time their recommendations to enhance their perceived stock-picking performance, analysts with poorer past performance, who are also in greater need for improvement in their performance, are more likely to time their recommendations after earnings announcements with

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