Making Sense of Cents

In our recently accepted Journal of Finance paper Making Sense of Cents: An Examination of Firms That Marginally Miss or Beat Analyst Forecasts, we provide evidence on the short and long-term price and profitability performance associated with managers undertaking myopic actions to meet short term earnings benchmarks, either through real operating decisions or management of accrual earnings. We also examine whether managers behave in a manner consistent with being aware of the short-term and long-term implications of their myopic choices. Our research design focuses primarily on two particular groups of firms: firms that just beat consensus forecasts (by one cent) but have large income increasing accruals and cuts in discretionary spending, and firms that just miss consensus forecasts (by one cent) but have large income decreasing accruals and increases in discretionary expenditures. We use these two sub-samples to yield the best possible contrasting settings of managerial myopia, where myopic actions are most likely and least likely to have been taken.

Our results show that in horizons of one year or less, firms using accruals or cuts in discretionary expenditures (i.e., low quality earnings) to beat a forecast have stock returns that are equal to or marginally better than firms who miss their forecast but maintain high quality earnings. Moreover, both these groups significantly outperform firms that manage earnings upwards but still miss expectations. This finding suggests a short-term benefit to beating expectations. In the long run, however, we find that firms that beat with low quality earnings under-perform the firms that miss with high quality earnings, which is consistent with the myopic behavior of the managers manifesting in the long-term. In addition, we find that future operating performance improves more for firms that miss with high quality earnings relative to firms that beat with low quality earnings, but this finding is limited to the subset of firms that are profitable. Among profitable firms, return on assets (ROA) increases for missers with high quality earnings relative to beaters with low quality earnings. Similarly, increases in capital expenditures are significantly higher and the market-to-book ratio increases more for firms that miss with high quality earnings. Lastly, we show firms that beat forecasts with low quality earnings are significantly more likely to issue equity in the following year and have significantly greater insider selling. These results hold regardless of whether the firms are compared with those that miss forecasts with high quality earnings or with those that beat forecasts with high quality earnings.

Our results suggest that while managers’ intuition regarding stock price benefits is correct in the short-term, the long-term rationale of this strategy is harmful because the quality of earnings manifests itself in performance over the long-run. We also provide empirical evidence that managers of these firms appear to understand these patterns, as they are significantly more likely to capitalize on the short term price benefits associated with beating the benchmark.

The full paper is available for download here.