IDEAS home Printed from https://ideas.repec.org/p/ysm/somwrk/amz2517.html
   My bibliography  Save this paper

The Impact of Earnings Surprises on Stock Returns: Theory and Evidence

Author

Listed:
  • Panos Patatoukas
  • Hongjun Yan

Abstract

This paper analyzes a dynamic general equilibrium model to study the impact of earnings surprises on contemporaneous stock returns. The model shows that earnings surprises can affect stock returns through two channels. On the one hand, earnings surprises affect the expected future earnings of the stock and so induce a positive earnings-returns correlation (cash flow effect). On the other hand, earnings surprises affect discount rates and so induce a negative earnings-returns correlation (discount rate effect). We show that the first channel is likely to dominate for most individual stocks, while the second channel can dominate for the aggregate stock market. Our model provides a theoretical foundation for the empirical findings in Kothari, Lewellen and Warner (2006) and generates two main implications: i) aggregate earnings surprises are positively related to interest rate changes, and ii) a stock’s return is less sensitive to earnings news if the stock’s earnings growth is more pro-cyclical. Our empirical evidence is consistent with both implications. More generally, our analysis illustrates that, due to the discount rate effect, firm-level phenomena may fail to extend to the aggregate stock market.

Suggested Citation

  • Panos Patatoukas & Hongjun Yan, 2009. "The Impact of Earnings Surprises on Stock Returns: Theory and Evidence," Yale School of Management Working Papers amz2517, Yale School of Management.
  • Handle: RePEc:ysm:somwrk:amz2517
    as

    Download full text from publisher

    File URL: http://icfpub.som.yale.edu/publications/2517
    Download Restriction: no

    References listed on IDEAS

    as
    1. Campbell, John Y, 1991. "A Variance Decomposition for Stock Returns," Economic Journal, Royal Economic Society, vol. 101(405), pages 157-179, March.
    2. Raj Chetty, 2006. "A New Method of Estimating Risk Aversion," American Economic Review, American Economic Association, vol. 96(5), pages 1821-1834, December.
    3. Ball, Ray & Watts, Ross, 1972. "Some Time Series Properties of Accounting Income," Journal of Finance, American Finance Association, vol. 27(3), pages 663-681, June.
    4. John Y. Campbell, Robert J. Shiller, 1988. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 195-228.
    5. Teets, Walter R. & Wasley, Charles E., 1996. "Estimating earnings response coefficients: Pooled versus firm-specific models," Journal of Accounting and Economics, Elsevier, vol. 21(3), pages 279-295, June.
    6. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, vol. 48(4), pages 817-838, May.
    7. Cecchetti, Stephen G & Lam, Pok-sang & Mark, Nelson C, 1990. "Mean Reversion in Equilibrium Asset Prices," American Economic Review, American Economic Association, vol. 80(3), pages 398-418, June.
    8. repec:bla:joares:v:6:y:1968:i:2:p:159-178 is not listed on IDEAS
    9. Taylor, Mark P, 1999. "Real Interest Rates and Macroeconomic Activity," Oxford Review of Economic Policy, Oxford University Press, vol. 15(2), pages 95-113, Summer.
    10. Sadka, Gil & Sadka, Ronnie, 2009. "Predictability and the earnings-returns relation," Journal of Financial Economics, Elsevier, vol. 94(1), pages 87-106, October.
    11. Alejandro Justiniano & Giorgio E. Primiceri, 2010. "Measuring the equilibrium real interest rate," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q I, pages 14-27.
    12. William M. Cready & Umit G. Gurun, 2010. "Aggregate Market Reaction to Earnings Announcements," Journal of Accounting Research, Wiley Blackwell, vol. 48(2), pages 289-334, May.
    13. Boudoukh, Jacob & Richardson, Matthew & Whitelaw, Robert F, 1994. " Industry Returns and the Fisher Effect," Journal of Finance, American Finance Association, vol. 49(5), pages 1595-1615, December.
    14. Nelson, Charles R & Schwert, G William, 1977. "Short-Term Interest Rates as Predictors of Inflation: On Testing the Hypothesis That the Real Rate of Interest is Constant," American Economic Review, American Economic Association, vol. 67(3), pages 478-486, June.
    15. Long Chen & Zhi Da & Xinlei Zhao, 2013. "What Drives Stock Price Movements?," Review of Financial Studies, Society for Financial Studies, vol. 26(4), pages 841-876.
    16. Bernard, Victor L., 1986. "Unanticipated inflation and the value of the firm," Journal of Financial Economics, Elsevier, vol. 15(3), pages 285-321, March.
    17. Pietro Veronesi, 2000. "How Does Information Quality Affect Stock Returns?," Journal of Finance, American Finance Association, vol. 55(2), pages 807-837, April.
    18. Fama, Eugene F. & Gibbons, Michael R., 1982. "Inflation, real returns and capital investment," Journal of Monetary Economics, Elsevier, vol. 9(3), pages 297-323.
    19. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-1445, November.
    20. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
    21. Ray Ball & Gil Sadka & Ronnie Sadka, 2009. "Aggregate Earnings and Asset Prices," Journal of Accounting Research, Wiley Blackwell, vol. 47(5), pages 1097-1133, December.
    22. Lakshmanan Shivakumar, 2010. "Discussion of Aggregate Market Reaction to Earnings Announcements," Journal of Accounting Research, Wiley Blackwell, vol. 48(2), pages 335-342, May.
    Full references (including those not matched with items on IDEAS)

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ysm:somwrk:amz2517. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (). General contact details of provider: http://edirc.repec.org/data/smyalus.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.