Post-Earnings-Announcement Drift: The Role of Revenue Surprises

Abstract

The study reported here consisted of estimating earnings and sales (or revenue) surprises either with historical time-series data or with analyst forecasts. Post-earnings-announcement drift was found to be stronger when the revenue surprise was in the same direction as the earnings surprise. This result proved to be robust to various controls, including the proportions of stock held by institutional investors, arbitrage risk, and turnover (prior 60-month average trading volume). This finding is consistent with prior evidence that earnings surprises have a more persistent effect on future earnings growth when they consist of higher revenue surprises than when they consist of lower expense surprises.

The study we report shows that the magnitude of post-earnings-announcement drift in security returns after the announcement of earnings depends on the magnitude of contemporaneous revenue surprises. When the two signals for a company confirm each other, drift is larger.

Drift is stronger when the revenue surprise is in the same direction as the earnings surprise quite probably because revenue surprises identify companies for which earnings surprises should have a more persistent effect on future earnings growth. This result held even after we controlled for the sophistication of investors (as indicated by the proportion of shares held by institutions), arbitrage risk (based on the correlation of the company returns with S&P 500 Index returns), and turnover (prior 60–month average trading volume). These results proved to be robust across subperiods, including the 1998–2002 period, which spanned extreme market fluctuations. The results proved to be robust also for three different subsamples of data—a large subsample of companies that had historical earnings and revenue data in the Compustat quarterly database, a subsample of companies for which at least two analysts provided earnings forecasts and historical revenue data were used, and a much smaller subsample of companies for which at least one analyst forecasted revenues as well as earnings. In all three cases, a portfolio of companies with extreme earnings surprises and extreme revenue surprises in the same direction earned significantly higher abnormal returns in the quarter after the preliminary earnings announcement.

These higher abnormal returns were most pronounced when we used analyst forecasts of both earnings and revenues to estimate the surprises. The difference between analyst forecasts of earnings and the actual earnings reported by I/B/E/S provided a better measure of earnings surprise than the difference between time-series estimates of earnings surprise garnered from Compustat data.

Naturally, the improvement in performance when we used a trading strategy based on revenue surprises as well as earnings surprises came at a minor cost; the portfolio of companies with extreme earnings and revenue surprises in the same direction comprised a smaller number of companies than the portfolio of companies with extreme earnings surprises alone. The portfolio of extreme revenue+earnings surprises nevertheless contained a sufficient number of companies for adequate portfolio diversification.

Investors and other market participants can use the evidence in this study to improve trading strategies that use earnings surprise as a signal. Revenue surprises can be useful as an additional signal to determine future earnings growth. Similarly, analysts can use revenue surprises when forecasting future earnings.

The results also indicate that analysts should carefully examine the sources of earnings surprises to forecast future earnings growth. Fundamental analysis should take into account the differential effects of revenue and expense surprises on the persistence of future earnings growth. In particular, earnings growth driven by revenue growth has a stronger effect on future earnings levels than does earnings growth stemming from expense reduction.

Finally, research into the reasons and implications of post-earnings-announcement drift should take into account the differential drift implications of revenue and expense surprises.