Prior Forecasting Accuracy and Investor Reaction to Management Forecasts by Amy P. Hutton and Phillip C. Stocken

Electronic copy available at: http://ssrn.com/abstract=817108

Prior Forecasting Accuracy and Investor Reaction to ManagementEarnings Forecasts*

Amy P. Hutton and Phillip C. StockenJune 8, 2009

Abstract

We examine the properties of firms’ forecasting records and whether theaccuracy of their prior earnings forecasts affects investor response to theirsubsequent forecasts. Within the context of a Bayesian model of investorlearning, we find that the stock price response to management forecast newsis increasing in prior forecast accuracy and also in the length of a firm’sforecasting record. Further, we document that investors are more responsiveto extreme good and bad news forecasts when a firm has an establishedforecasting record. Overall, these results suggest that a firm’s priorforecasting behavior allows it to establish a forecasting reputation.

JEL Descriptors

G19, G39, D89, M40

*

Corresponding Author:ahutton@bc.edu; 617 552-1951 phone; 617 552-6345 fax;Fulton Hall 520, 140 Commonwealth Ave. Chestnut Hill, MA 02467-3808

*

We thank Ray Ball, Steve Baginski, Linda Bamber, Ken French, Charles Hsu, Michael Kimbrough, S.P.Kothari, Rafael La Porta, Franco Wong, Eric Yeung, Valentina Zamora, an anonymous referee, andworkshop participants at Boston College, Boston University, Carnegie Mellon University, EmoryUniversity, INSEAD, University of Georgia, MIT Sloan School of Management, Tuck School of Business,George Washington University, FEA Conference at the University of North Carolina, Chapel Hill and the2006 American Accounting Association annual meetings for helpful comments. Finally, we thank RobertBurnham for excellent research assistance.

Electronic copy available at: http://ssrn.com/abstract=817108

1. INTRODUCTION

Firms often voluntarily provide earnings guidance. A key feature of this guidance isthat the manner in which firms gather and communicate their forward-lookinginformation is far less regulated than their mandatorily disclosed financial statementinformation. Consequently, it is important that investors assess the accuracy of a firm’sforward-looking information when valuing the firm. While previous research hasempirically examined whether a firm’s single most recent earnings forecast affects theresponse of equity analysts to its current forecast (see Williams 1996), there is a dearth of research exploring the properties of firms’ forecasting records and how investors evaluatethem. This study uses

First Call

’s Company Issued Guidance (

CIG

) data base and takes afirst look at the properties of firms’ forecasting records and how firms’ prior forecastingbehavior affects investor reaction to their current earnings forecasts.

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To characterize the properties of firms’ earnings forecasts, we consider two constructsof management forecast accuracy:

Relative Accuracy,

which refers to the accuracy of themanagement forecast relative to the accuracy of the prevailing consensus analyst forecast,and

Absolute Accuracy

, which equals the magnitude of the difference between theearnings realization and the earnings forecast. Using a sample of earnings forecastsissued by publicly traded firms between 1994 and 2007, we create cumulative measuresof relative and absolute accuracy. We find that prior forecast accuracy is useful forexplaining current forecast accuracy using the

Relative Accuracy

measure, but onlymarginally so for the

Absolute Accuracy

measure.

1

Throughout the paper we refer to management forecasts and firm forecasts interchangeably. Moreover,our research design assumes that a forecasting record or reputation attaches to the firm and its managementteam rather than to a particular manager. If this presumption is incorrect, and if the manager responsible forearnings guidance leaves the firm, then the power of our tests is weakened.

1

To assess the effect of a firm’s forecasting history on the credibility of its currentearnings guidance, we follow prior research that defines forecast credibility as the extentto which investors believe the current forecast and measures forecast credibility as thestock price reaction to the forecast (e.g., Jennings 1987; Hutton, Miller, and Skinner2003). We find the stock price reaction to the forecast news is increasing in eithermeasure of prior forecast accuracy, consistent with investors assessing a firm’sforecasting record when responding to its current forecast. Using a Bayesian model of investor learning, we predict that investor responsiveness to a firm’s current forecast isincreasing in the accuracy and the number of the firm’s prior forecasts. We presentevidence consistent with investors assessing the relative accuracy rather than the absoluteaccuracy of the firm’s prior forecasts. Lastly, we consider investor reaction to extremegood and bad forecast news. Here we classify firms as having either a strong or a weak forecasting record compared to other firms in its industry and find that investors are moreresponsive to extreme news when a firm has established a strong forecasting record. Insummary, our evidence suggests that firms develop reputations for accurate forecastingand that a favorable forecasting reputation increases the credibility of managementearnings forecasts.This study should be of interest to firm management, policy-makers, and regulators.Management ought to find it interesting because it suggests firms benefit fromdeveloping favorable forecasting records. When firms have established a reputation forforecasting accurately, the market is more responsive to their forward-lookinginformation, even though the information it is not immediately verifiable or auditable.Further, because investors are more responsive to forecast news when the forecasting2