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Research Finds That Managing Earnings Causes More Long-Term Harm Than Short-Term Good to Stock Price

Investors who buy a stock based only on whether a firm's earnings beat analysts' expectations are seeing just a part of the picture, according to a study by a University of Iowa researcher.

Paul Hribar, associate professor of accounting in the Tippie College of Business, suggests investors would do well to also consider how a firm beat or missed its forecast. According to his recently published study, firms that narrowly beat their forecasts by heavily managing their earnings have a lower stock performance in the following three years than firms that narrowly miss their targets but leave their balance sheets alone.

"Our study indicates that the quality of a firm's earnings should be just as important as the earnings themselves when assessing the value of a firm beating expectations," said Hribar, whose paper, "Making Sense of Cents," was recently published in the Journal of Finance.

Hribar said the study shows that a firm that comes up just short of its earnings forecast generally doesn't deserve to have its stock price pummeled by the market, as so often happens. At the same time, it shows the chickens do come home to roost for firms that manipulate their balance sheets to clear the earnings bar set by analysts.

Hribar and his coauthors—Sanjeev Bhojraj of Cornell University's Johnson Graduate School of Management, Marc Picconi of Indiana University's Kelley School of Business, and John McInnis of the University of Texas at Austin's McCombs School of Business—looked at companies that beat or missed their targets by 1 cent between 1988 and 2001. The researchers chose the 1-cent benchmark because prior research has shown those are companies that tend to most actively manage their earnings.

They then examined whether those firms aggressively managed their earnings, either by adjusting their accounting reserves, or by cutting back on research and development or advertising to reduce expenses. Hribar said the researchers chose research and development and advertising because while cutting those expenses can boost short-term earnings, the cuts tend to have negative long-term effects. Research and development, as well as advertising, are necessary for a firm's future growth.

Their analysis found that the stock prices of the firms that beat analyst's targets by heavily managing earnings perform well at first, but that performance drops significantly over time. That trend does not hold for firms that missed their target but did not manage earnings.

The study looked at 1,367 firms that missed its forecast by 1 cent, and 2,099 that beat the forecast by 1 cent. They found that firms that aggressively manage reserves to meet analyst forecasts are outperformed by firms that miss expectations by 1.1 percent in the first year, 3.5 percent in the second year, and 15.5 percent in the third year.

Similarly, firms that narrowly meet expectations by cutting research and development expenses are outperformed by firms that narrowly miss expectations by 5.6 percent in two years and 35.6 percent in three years.

Overall, firms that beat earnings forecasts and have low quality earnings underperform the market by 10.3 percent in the three-year window; firms that miss expectations and report high quality earnings outperform the market by 30 percent.

"This finding suggests that while the miss-beat effect seems to dominate in the short-run, quality of earnings manifests itself in performance over the long run," Hribar said. "While missing or beating expectations does provide some information about a firm's future prospects, integrating information about how the firm met their expectations increases the predictive ability of this measure."


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