Management Earnings Forecasts During Price Pressure: Evidence From Mutual Fund Trades
New York University (NYU) – Leonard N. Stern School of Business
June 6, 2016
Does a company’s stock mispricing influence its decision to issue an earnings forecast? Does executive compensation affect the nature of the forecast? How does the market react to these forecasts? I address these questions using cross-sectional and time-series variation in stock mispricing related to the liquidity-driven trades of mutual funds. I find that managers issue earnings forecasts more frequently when their company’s stock appears mispriced. In answering the second question, I uncover unintended consequences of executive compensation schemes, in that managers of mispriced firms strategically withhold information from investors to benefit from stock option exercises. I also show that in responding to forecasts of mispriced firms, investors act as if they are able to distinguish informative management earnings forecasts from uninformative ones. Finally, the difference-in-differences estimations lend credibility to the results by exploiting the exogenous fund outflows due to the 2003 mutual fund trading scandal. Collectively, my findings highlight the interplay between stock mispricing, managerial earnings forecast incentives, the company’s resulting disclosure policy, and the market reaction to it.
Management Earnings Forecasts During Price Pressure: Evidence From Mutual Fund Trades – Introduction
While managers have various reasons for issuing earnings forecasts, a frequently mentioned one concerns correcting investors’ assessments of the firm’s prospects. Graham et al. (2005) report that according to CFOs “… the primary role of voluntary disclosure is to correct investors’ perceptions about current or future performance, so that the stock is priced off company provided information rather than misinformation.” Regulators seem to agree, as management earnings forecasts are exempt from auditing and the safe harbor provisions (passed in 1979) and PSLR Act (1996) shield managers from legal liability for issued forecasts. However, the issuance of management earnings forecasts is associated with unintended consequences. According to practitioners, managers of forecasting firms tend to focus on short-term results at the expense of the long-term value (McKinsey 2006, Deloitte 2009); consequently, consultants discourage the practice of providing earnings forecasts.
Researchers are also critical of the practice of providing management earnings forecasts. They provide ample evidence of opportunistic use of management earnings forecasts, including the issuance of forecasts to manage analysts’ expectations (Matsumoto 2002), to influence the strike price of option awards (Aboody and Kasznik 2000), and to profit from options exercises (Brockman et al. 2010).
The apparent contradictory views on the desirability of management earnings forecasts justify further research. To provide new insights on this issue, I focus on an empirical setting of equity mispricing due to price pressure from liquidity-driven trades of mutual funds (details in Section 3). Specifically, I address three research questions. (1) Does a company’s stock mispricing influence its decision to issue an earnings forecast? (2) Does managerial compensation affect the nature of forecasts issued during the mispricing? (3) How does the market react to these forecasts?
To address the first research question, I examine the frequency of management earnings forecasts issued by mispriced firms. In general, managers of mispriced firms can choose from three mutually exclusive earnings forecast strategies. First, they can ignore the mispricing and let the market correct it over time. Second, managers can step in and issue a corrective forecast, i.e., information to speed up price recovery (Graham et al. 2005). Third, managers may issue a prolonging forecast, i.e., information to sustain the mispricing (Jensen 2004).
The first strategy may follow because the market will eventually correct the mispricing (Coval and Stafford 2007); hence, managers may find little incentive to interfere especially if they value the quiet life (Bertrand and Mullainathan 2003). Alternatively, managers can choose the second strategy (i.e., issuing a corrective forecast) to ensure that the company’s equity is priced according to fundamentals. This argument is supported, for example, by the annual report of Berkshire Hathaway (1988): “We do not want to maximize the price at which Berkshire shares trade. We wish instead for them to trade in a narrow range centered at intrinsic business value… [We] are bothered as much by significant overvaluation as significant undervaluation.” Corrective earnings forecasts may alleviate the costs of mispricing to the firm, such as a decline in the firm’s investment (Lou and Wang 2014) and employment (Hau and Lai 2013). In addition, corrective earnings forecasts may help managers to keep their jobs by reducing the risk of mispricing related threats, such as the threat of hostile takeovers (Edmans et al. 2012), and activism campaigns (Gantchev and Jotikasthira 2015).
Pursuing the third strategy, in which the mispricing is allowed to persist, may enable managers and shareholders to reap certain benefits. Managers can sell company’s shares if the firm is overvalued (Khan et al 2012) and buy shares if the firm is undervalued (Ali et al. 2011). In addition, managers get valuable stock options with a low strike price if the firm is undervalued (Ali et al. 2011). Shareholders may also find undervaluation beneficial because it deters potential competitors and may help the firm to renegotiate contracts with debt-holders, lessors (Benmelech and Bergman 2008), and trade unions (Benmelech et al. 2012). If these benefits are substantial, managers may issue earnings forecasts to prolong the mispricing rather than to correct it. Given all aforementioned incentives, I expect to find a higher frequency of earnings forecasts among mispriced firms relative to firms with unbiased stock prices (Hypothesis 1).
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