Bad News on Earnings? Be More Skeptical

Beware of bad-news earnings forecasts -- they tend to be less reliable than predictions of good news, according to a study by Helen Hurwitz, an accounting doctoral student at the Columbia University School of Business.

Hurwitz’s research, presented at the recent annual meeting of the American Accounting Association, finds that management’s bad-news forecasts are significantly more likely than the good-news variety to err on the upside, overestimating at what level earnings will be in an effort to soften market reaction.

Stock price swings suggest that’s the opposite of conventional wisdom. Investors usually view good-news forecasts with more skepticism than bad ones, with a negative forecast pushing a company’s stock down by as much as 10%, while the rise for good news is only 2%. If bad-news forecasts are less reliable, such a big drop is probably an overreaction.

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It’s “not that bad-news forecasts are more credible, as is widely believed, but just the opposite -- that investors tend to view them as less credible,” said Ben Haimowitz of the American Accounting Association.

Managers tend to be more cautious when issuing good-news forecasts, something Hurwitz attributes in large part to Reg FD, the full-disclosure rule imposed by the Securities and Exchange Commission in 2000. This rule requires management forecasts to be made to the public instead of to selected groups of analysts or institutions, which “reduces the optimistic bias in good-news management forecasts,” Hurwitz says.

Forecasts were defined for the research as good news or bad news depending on whether they were higher or lower than analyst consensus forecasts over the three months prior to the company’s prediction. The degree of optimism was determined by comparing the forecasts to the actual earnings at year’s end.

Threat of litigation is the main reason for the gap in credibility between good-news and bad-news forecasts. Companies are less likely to get sued for having better than expected results than for issuing forecasts that later prove too rosy. In other words, it’s more difficult to sue a firm for issuing a bad-news forecast. “Litigation risk reduces the optimism in good-news forecasts, but has no effect on bad-news management forecasts,” Hurwitz says.

The takeaway for investors: If a downbeat annual forecast issued by a firm prompts a steep decline in its stock, and the news doesn’t seem to warrant such a sharp decline, proceed with caution, Hurwitz says. “The market believes that the company’s outlook is worse than its announcement suggests, and, based on the findings of this study, it is likely that the market is right.”