Significance of Forecast Precision: The Importance of Ex-Ante Expectations

Abstract

Cornell University 2011I investigate whether the precision of an earnings forecast interacts with environmental uncertainty to affect investors' perceptions of management credibility, future firm growth, and firm stock price. I find that investors respond to a misalignment between environmental uncertainty and forecast precision by lowering their growth expectations and stock price estimates (lowering growth expectations and penalizing price estimates when point forecasts are issued in relatively uncertain environments or range forecasts are issued in relatively certain environments). I find a similar pattern of results for investors' perceptions of management credibility.Perceptions of management credibility mediate the impact of misalignment on investors' perceptions of future growth but do not mediate the impact of misalignment on stock price estimates. My findings have implications for managers issuing forecasts and for investors interpreting forecasts.iii BIOGRAPHICAL SKETCHKathy will receive her PhD from Cornell University's Johnson Graduate School of Management, obtained bachelors and masters of accounting degrees from the University of Illinois at Urbana-Champaign, and received a CPA certification from the state of Illinois. Prior to joining the academic world, she spent a short period of time in the audit industry.As of August 2010, Kathy is an Assistant Professor at the University of Florida's Fisher School of Accounting. She teaches in the area of financial reporting.On the research front, her curiosity of human behavior has led her to investigate the unexpected ways in which market participants interpret different formats and disclosures of financial information. Some of her current projects look into how the combination of what investors expect and managers disclose affects firm stock price, how investors make risk judgments, and why some analysts can be more accurate yet more biased in their forecasts at the same time.Outside of the office, Kathy works on improving her tennis game, enjoys biking and keeping active, and adores the company of her two rambunctious felines. This research contributes to the current literature in several respects. First, Iidentify one reason that may explain why prior behavioral studies have not documented an effect of forecast precision immediately following an earnings forecast. Since prior studies were designed to focus on characteristics of the forecast and not investors' expectations about forecast precision, prior research has not examined how the cues provided by forecast precision interact with pre-existing investors' expectations. I provide the first evidence that pre-existing expectations interact with forecast precision to affect growth expectations and stock price estimates.Second, by documenting an effect of forecast precision immediately after earnings guidance, I highlight the significance of this formatting choice to management and suggest that further investigation of the effects of forecast precision are warranted.For example, format expectation...

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“…Instead of asking for ratings of intelligence, likeability, or willingness to rely on the manager, I focus on attitudes about managers’ credibility to be consistent with prior work in accounting (see e.g., Barton and Mercer [2005], Mercer [2005], Venkataraman [2008], Clor‐Proell [2009], Koonce and Lipe [2010], Rupar [2011], Tan, Wang, and Zhou [2011]). 5 H3 focuses on evaluations of management credibility, and predicts:…”

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“…Maletta and Zhang's [2011] paper is an example of how guidance characteristics and environmental factors sometimes interplay to affect investors' reactions to earnings guidance. Rupar [2011] suggests that investors consider a firm's operating environment uncertainty when reacting to earnings guidance. Rupar [2011] introduces investors' ex ante expectations induced from environmental uncertainty as a factor and examines its joint effect with guidance form on investor earnings estimates.…”

“…Rupar [2011] suggests that investors consider a firm's operating environment uncertainty when reacting to earnings guidance. Rupar [2011] introduces investors' ex ante expectations induced from environmental uncertainty as a factor and examines its joint effect with guidance form on investor earnings estimates. Rupar [2011] finds that investors' earnings estimates (as well as their assessments of management credibility) are higher when guidance precision and investor expectations are aligned (precise/less precise guidance form with low/high environmental uncertainty) than when they are not aligned (less precise/precise guidance form with low/high environmental uncertainty).…”

“…Koonce et al [2012] express concern that investors may not be able to attend to the completeness of management explanations. Future research might examine attribution effects in the earnings guidance context and thereby complement archival research in this area [Rupar, 2011].…”

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