Evidence that Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings: An Experimental Markets Approach *

Evidence that Prices Do Not Fully Reflect the Implications of Current Earnings for Future... Abstract. Analysts have been found to underweight the innovation in the most recent quarterly earnings when forecasting next‐quarter earnings, and these expectations have been posited as an explanation for post‐earnings‐announcement drift. This study uses an experimental asset market to examine whether similar errors in forecasting quarterly earnings are made by student‐subjects. We examine two aspects of their behavior: (1) do subjects underestimate the autocorrelation in quarterly earnings when forming earnings expectations? and (2) are asset prices consistent with a subject's underestimation of the autocorrelation in quarterly earnings? We observe subject errors in forecasts that underweight extreme innovations in the most recent quarterly earnings by approximately 40 percent. The prices in the experimental markets also fail to reflect fully the most recent innovation in quarterly earnings. We are able to predict the sign of the incorrect pricing, from the mean initial earnings predictions of the subjects, in 74 percent of the 135 markets. These forecast errors observed in this study are consistent with forecast errors observed for analysts, and this consistency suggests that errors in analysts' forecasts may be at least partially attributable to the use of judgmental heuristics. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Contemporary Accounting Research Wiley

Evidence that Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings: An Experimental Markets Approach *

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Publisher
Wiley
Copyright
1997 Canadian Academic Accounting Association
ISSN
0823-9150
eISSN
1911-3846
D.O.I.
10.1111/j.1911-3846.1997.tb00534.x
Publisher site
See Article on Publisher Site

Abstract

Abstract. Analysts have been found to underweight the innovation in the most recent quarterly earnings when forecasting next‐quarter earnings, and these expectations have been posited as an explanation for post‐earnings‐announcement drift. This study uses an experimental asset market to examine whether similar errors in forecasting quarterly earnings are made by student‐subjects. We examine two aspects of their behavior: (1) do subjects underestimate the autocorrelation in quarterly earnings when forming earnings expectations? and (2) are asset prices consistent with a subject's underestimation of the autocorrelation in quarterly earnings? We observe subject errors in forecasts that underweight extreme innovations in the most recent quarterly earnings by approximately 40 percent. The prices in the experimental markets also fail to reflect fully the most recent innovation in quarterly earnings. We are able to predict the sign of the incorrect pricing, from the mean initial earnings predictions of the subjects, in 74 percent of the 135 markets. These forecast errors observed in this study are consistent with forecast errors observed for analysts, and this consistency suggests that errors in analysts' forecasts may be at least partially attributable to the use of judgmental heuristics.

Journal

Contemporary Accounting ResearchWiley

Published: Sep 1, 1997

References

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