Earnings Announcements, Aggregate Earnings, and Individual-Firm Stock Returns: A Signal Extraction Perspective

49 Pages Posted: 17 Jan 2012

See all articles by James R. Frederickson

James R. Frederickson

Melbourne Business School

John D. Lyon

The University of Melbourne, Department of Accounting and Business Information Systems

Leon Zolotoy

University of Melbourne - Melbourne Business School

Date Written: January 16, 2012

Abstract

There is an extensive stream of research that documents a positive association between earnings surprises and stock returns at the individual firm level. We posit that individual firms’ earnings surprises have systematic and firm-specific components that differ in their persistence, implying that the market reaction to individual firms’ earnings surprises should depend upon the relative magnitudes of the underlying systematic and firm-specific earnings surprise components. We further posit that investors behave as if they solve a signal extraction problem that allows them to estimate from aggregate (e.g., market) earnings the systematic earnings surprise component. Our signal extraction framework implies that the market reaction to individual firms’ earnings surprises is increasing in the cross-sectional mean earnings surprise and that the magnitude of the mean effect is inversely related to the cross-sectional dispersion of the earnings surprises. Our results are consistent with these predictions. Also consistent with signal extraction, we find that the effect of the crosssectional mean earnings surprise is significantly larger for firms that announce their earnings early in the quarter. We also find that signal extraction occurs for firms with a large percentage of individual investors, but not a large percentage of institutional investors, consistent with institutional investors having private information that allows them to partition a firm’s earnings surprise into its systematic and firm-specific components. Overall, our results suggest that to understand the market reaction to individual firms’ earnings announcements, one must consider aggregate earnings.

Keywords: aggregate earnings, signal extraction, systemic component, persistence

JEL Classification: M41, G10

Suggested Citation

Frederickson, James R. and Lyon, John D. and Zolotoy, Leon, Earnings Announcements, Aggregate Earnings, and Individual-Firm Stock Returns: A Signal Extraction Perspective (January 16, 2012). Available at SSRN: https://ssrn.com/abstract=1986457 or http://dx.doi.org/10.2139/ssrn.1986457

James R. Frederickson

Melbourne Business School ( email )

200 Leicester Street
Carlton, Victoria 3053
Australia

John D. Lyon

The University of Melbourne, Department of Accounting and Business Information Systems ( email )

Victoria
Melbourne, 3010
Australia

HOME PAGE: http://www.abis.unimelb.edu.au/who/staff/john_lyon.html

Leon Zolotoy (Contact Author)

University of Melbourne - Melbourne Business School ( email )

200 Leicester Street
Carlton, Victoria 3053 3186
Australia

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