The Divergence of Street from GAAP Earnings and Stock Mispricing

Abstract

How and why do the differences between Street and GAAP earnings predict stock returns? To shed more light on that question, we provide robust evidence to show that the differences negatively predict future stock returns, but not future cash flows. A trading strategy that sorts stocks on the differences generates an economically significant profit. In investigating the economic nature of the differences, we discover that they reflect managers' opportunistic biases. Firms with greater earnings differences have greater earnings surprises, intangible capital investments, and stock issuances. Further evidence discloses that investors' inability to completely understand the opportunistic part of the differences causes stock mispricing and stocks with greater earnings differences are more overpriced. Accordingly, the negative differences-return relation is stronger following high-sentiment periods and in stocks with greater limits to arbitrage. Furthermore, a decomposition method shows that approximately half of the negative relation can be explained by stocks' mispricing levels.

Keywords: Earnings Differences, Investment Strategies, Managers’ Bias, Stock Mispricing

JEL Classification: G12, G14