Philip B. Shane

Changes in Cash: Persistence and Pricing Implications

This paper decomposes the cash component of earnings and analyzes persistence characteristics and pricing implications of various subcomponents, with particular attention on changes in cash. Changes in underlying fundamentals might dictate changes in cash to new optimal levels. Alternatively, suboptimal changes in cash might result from agency costs allowing managers’ actions to diverge from the best interests of shareholders. We predict and find that both suboptimal increases and decreases in cash bode poorly for future earnings. In fact, we find that suboptimal increases (decreases) in cash have less (greater) persistence than any of the earnings components we study, including accruals and net distributions to both shareholders and debt holders. Market efficiency tests indicate that the market severely punishes firms with suboptimal decreases in cash, but we find no evidence to support the hubris hypothesis that the market overreacts to the earnings implications of unwarranted increases in cash.

Changes in Cash: Persistence and Pricing Implications: CHANGES IN CASH

This paper decomposes the cash component of earnings and analyzes persistence characteristics and pricing implications of various subcomponents, with particular attention to changes in cash. Changes in underlying fundamentals might dictate changes in cash to new optimal levels. Alternatively, suboptimal changes in cash might result from agency costs allowing managers’ actions to diverge from the best interests of shareholders. We predict and find that both suboptimal increases and decreases in cash bode poorly for future earnings. In fact, we find that suboptimal increases (decreases) in cash have less (greater) persistence than any of the earnings components we study, including accruals and net distributions to both shareholders and debt holders. Market efficiency tests indicate that the market severely punishes firms with suboptimal decreases in cash, but we find no evidence to support the hubris hypothesis that the market overreacts to the earnings implications of unwarranted increases in cash.

A COMPARATIVE-ANALYSIS OF FIRMS INCLUDED IN AND EXCLUDED FROM THE NAARS DATABASE

In this paper we provide evidence on the representativeness of the NAARS database by comparing various characteristics of COMPUSTATI CRSP domestic industrial firms included in the database (included firms) to characteristics of otherwise similar firms that are not included (excluded firms). Our analysis covers both 1985 and 1990 and, although somewhat sensitive to the year analyzed and exchange listing, the results suggest that excluded firms tend to be smaller, with higher probabilities of both bankruptcy and qualified opinions; they are also more likely to be audited by a non-Big-Eight firm. The NAARS database is often used to select firms based on some nonnumerical characteristic such as a modified audit opinion or a specific footnote disclosure. Ball and Foster [1982] suggest that using NAARS results in larger and possibly more representative samples, while others note that samples drawn from the NAARS database may not be representative (Bowen and Noreen [1981], Elliott [1982], and Bell and Tabor [1991]). Representativeness affects the generalizability of empirical research results. Since accounting and auditing research often has potential implications for policy decisions, it is important to ensure adequate representation of the population of interest so that appropriate conclusions

Do connections with buy-side analysts inform sell-side analyst research?

We hypothesize that connections with buy-side analysts provide a sell-side analyst with private information generated by the buy-side that enhances the quality of sell-side research. We proxy for these connections with the number of stocks at the intersection of stocks held in the portfolios of institutional investors and followed by the sell-side analyst. The larger this intersection, the more opportunities the sell-side analyst has to interact with institutional investors. We proxy for the research quality of the sell-side analyst with the relative accuracy of her earnings forecasts. We find that such connections enhance the accuracy of earnings forecasts, but up to a point of diminishing returns. Additional tests rule out that the observed association is due to reverse causality.

Financial Analysts’ Long-Term Growth Forecasts and Market Efficiency with Respect to Firms’ Innovative Efficiency

Prior research finds that investors have difficulty pricing corporate innovation. This paper investigates the role of long-term growth forecasting financial analysts in the efficiency of stock prices and consensus sell-side analyst forecasts, with respect to information about firms’ innovative efficiency (IE). We find that, on average, like stock prices, financial analysts’ consensus earnings and target price forecasts reflect underreaction to IE-related information. We also find that evidence of analyst and investor underreaction is limited to R&D-intensive firms not followed by long-term growth forecasting analysts. We investigate two alternative perspectives on the mechanism underlying these results. The underreaction-mitigation perspective argues that long-term growth forecasting analysts cultivate increased analyst and investor attention to IE-related information and its implications for research-intensive firms’ near- and long-term prospects; thereby, mitigating underreaction in stock prices and in consensus analysts’ earnings and target price forecasts. The offsetting-bias perspective argues that optimistically biased long-term growth forecasts beget optimism in stock prices and consensus analysts’ forecasts, which, in turn, offsets investor and analyst underreaction giving the appearance of underreaction dissipation for firms followed by long-term growth forecasting analysts. Overall, the weight of the evidence from a battery of tests favors the underreaction-mitigation perspective.

Information in the tails of the distribution of analysts' quarterly earnings forecasts

Investors generally measure earnings announcement news on the basis of the difference between actual earnings and two salient benchmarks: earnings in the same quarter the previous year and a consensus drawn from a distribution of forecasts by financial analysts. We evaluate the implications of a third salient benchmark: the most optimistic forecast when actual earnings exceed the consensus and the most pessimistic forecast when the consensus exceeds actual earnings. We find that considering the information in these tails of the distribution of analysts’ earnings forecasts enhances the profitability of post–earnings announcement drift strategies. Editor’s note: This article was reviewed and accepted by Robert Litterman, executive editor at the time the article was submitted.