RESEARCH Business Economy

WALL STREET
To beat earnings expectations, first you have to lower them

Mark Reutter, Business Editor
(217) 333-0568; mreutter@uiuc.edu

2/1/02

CHAMPAIGN, Ill. — You needn't cook the books to make yourself look good on Wall Street. A safer approach is to talk down your company's fortunes to analysts before springing a "better-than-expected" earnings announcement for the quarter.

"Beating the forecast" does wonders for a company's stock price. A University of Illinois economist who analyzed thousands of forecasts of publicly owned companies between 1989 and 1998 found that there was a significantly higher probability for a company to beat the consensus forecast if the forecast was lowered two weeks prior to the announcement.

"We document empirically that many firms apparently have ways of lowering the forecasts as the earnings announcement date approaches," said Dan Bernhardt, the UI economist who conducted the study with Murillo Campello, an economist at Michigan State University.

"Companies have enormous incentives to manage earnings so as to generate quarterly results that exceed the consensus forecast," Bernhardt said in an interview. A company's stock price tends to rise following a "positive earnings surprise" and typically tumbles following a report that is below what analysts had predicted.

The economists found that the chance of a positive earnings surprise increased when late forecasts lowered the consensus forecast. This finding is "the opposite of what would be predicted if deviations of late forecasts from the consensus were due to the arrival of new or better information," Bernhardt said.

Examining the evidence empirically, "we found overwhelming evidence that investors are 'fooled' by late arriving forecasts that change the consensus. We cannot make such inferences about analysts who have complex relationships to maintain with the companies they cover."

Bernhardt theorized that less experienced analysts were more likely to make late forecasts and were more likely to revise their forecasts than analysts who had covered a company for a longer period. Also there is sometimes a legitimate reason for management to lower expectations, or create "slack." Especially in fast-growing companies, earnings may change dramatically in the weeks or even days before a quarter ends.

"A firm that expects earnings to fall far short of the consensus may give up on beating the consensus and take a one-time earnings bath," the UI economist said. "Conversely, a firm that expects earnings to greatly exceed the consensus may want to shift some earnings forward, saving financial slack for future quarters where beating the consensus may be more difficult."

Remember that corporate earnings announcements are not audited and are not reviewed by regulators. Essentially public relations documents, they often exclude basic costs such as marketing and interest that are required in audited filings to the Securities and Exchange Commission.

The Bernhardt-Campello working paper is titled "The Dynamics of Forecast Management."