Time-Varying Earnings Persistence and the Delayed Stock Return Reaction to Earnings Announcements

53 Pages Posted: 6 Feb 2012

See all articles by Changling Chen

Changling Chen

University of Waterloo - School of Accounting and Finance

Date Written: September 12, 2011

Abstract

This paper examines how investors assimilate firm-specific earnings persistence into prices in the context of delayed stock return reactions to earnings announcements (i.e., post-earnings-announcement drift, or PEAD). The literature predicts that if investors fail to recognize fully the time-series auto correlations in a firm’s earnings series (a time-series measure of earnings persistence, or time-series persistence), the magnitude of PEAD will increase with the level of the auto correlations. However, subsequent research demonstrates that the magnitude of PEAD is invariant to time-series persistence, which is inconsistent with the argument that PEAD reflects the market inefficiency caused by investors’ inability to differentiate earnings persistence across firms. I approach the issue from a new perspective, arguing that at the firm level, earnings persistence varies with changing accounting and economic fundamentals over time (a cross-sectional measure of earnings persistence, or time-varying persistence), which is an earnings attribute not captured by time-series persistence. I show that although the magnitude of PEAD is invariant to time-series persistence, it increases with time-varying persistence and investors appear to revise their expected persistence in the direction suggested by changing fundamentals after earnings announcements. Moreover, for firms that have complex information structures, I establish a link between investors’ trend-extrapolation heuristic and their recognition bias in time-varying persistence. Taken together, my results indicate that PEAD appears to arise from investors’ delay in incorporating the complex information about fundamentals necessary to estimate time-varying (but not time-series) persistence. This implies that information complexity triggers the market inefficiency in assimilating firm-specific time-varying earnings persistence into prices.

Keywords: earnings-announcement drift, earnings persistence, information complexity

JEL Classification: G12, G14, M41

Suggested Citation

Chen, Changling, Time-Varying Earnings Persistence and the Delayed Stock Return Reaction to Earnings Announcements (September 12, 2011). Contemporary Accounting Research, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1998876

Changling Chen (Contact Author)

University of Waterloo - School of Accounting and Finance ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1 N2L 3G1
Canada

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