CLS Blue Sky Blog

How Earnings Announcements Discipline Markets Skewed by Media Coverage

Earnings announcements serve a well-recognized role of conveying important information about firm performance to the market. However, an often-overlooked role of earnings releases is their ability to discipline market expectations.

Our study examines this disciplining role in the context of media sentiment – more specifically, whether earnings releases help constrain potential mispricing that results from the media’s overly positive or negative coverage of a firm. Our central finding is that quarterly media sentiment, or the overall tone of media coverage about a company during its fiscal quarter, negatively correlates with the stock market’s reaction to its earnings announcement. This relation suggests that earnings announcements play an important role in curbing mispricing that can arise from media sentiment.

We worked with a large dataset of more than 100,000 firm-quarters from 2007 to 2017 and analyzed media sentiment using data from RavenPack, which provides sentiment scores for millions of media articles from thousands of media outlets. Using these data, we developed several novel measures of media sentiment that account for factors such as the market influence of the media outlet and the novelty of individual articles. We also created a weighted measure of media sentiment that isolates the portion of the company’s stock returns driven by sentiment, unrelated to common risk factors and fundamental news.

Our findings best fit within what is known as a “higher order belief” framework, which acknowledges that different types of investors have different information and investment horizons. In particular, some investors are more interested in predicting short-term price movements than focusing on traditional valuation models. Some of these short-term investors may be willing to temporarily deviate from fundamentals to gain returns based on their short-term price predictions.

Important public signals (such as media coverage of the firm in our setting) can thus lead to price movements that are detached from the underlying fundamentals of the company as they influence average investor trading. This results in overweighting of these public signals, leading to price overreactions. Our central idea is that it can take another significant public event, in our case an earnings announcement, to correct these overreactions, as it helps to synchronize investors’ trading in the opposite direction. This leads to our finding that media sentiment can result in temporary mispricing, which is then eliminated when the earnings are announced.

Increasing our confidence in this result, we also find that the strength of this relation varies in ways that we would expect; for example, it gets stronger when the firm has many retail and transient institutional investors. Similarly, consistent with the expectation that investors are more likely to deviate from fundamentals when there is greater uncertainty about the company’s future cash flows, we observe stronger results for firms with greater fundamental uncertainty. We also see stronger results when there are greater constraints to short-selling, a situation that tends to lead to more mispricing, on average.

Overall, our findings provide evidence that quarterly earnings announcements play an important role in constraining mispricing associated with media sentiment. This evidence is relevant to the policy debate about the role of earnings in capital markets and the value that quarterly earnings releases provide to market participants. Many have called for an end to quarterly earnings reports, arguing that they induce myopic behavior by investors and managers. While our results do not speak to the potential costs of requiring firms to report quarterly earnings, they do shed new light on one often overlooked benefit, the ability of earnings to constrain mispricing, in our setting mispricing related to media sentiment.

Our findings also improve our understanding of the role of the media in capital markets. A number of studies have shown that media sentiment can dramatically influence the trading decisions of investors and, in turn, affect firms’ stock prices. Our results suggest that financial reporting can be a useful disciplining mechanism where sensational media sentiment has unduly affected investors.

This post comes to us from professors Eric Holzman and Brian Miller at Indiana University and Brady Twedt at Texas A&M University. It is based on their recent article, “Curbing Enthusiasm: Media Sentiment and the Disciplining Role of Quarterly Earnings Announcements,” forthcoming in The Accounting Review and available here.

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