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

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.