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This paper finds that firms that meet or beat current analysts’ earnings expectations (MBE) enjoy a higher return over the quarter than firms with similar quarterly earnings forecast errors that fail to meet these expectations. Further, such a premium to MBE, although somewhat smaller, exists in the cases where MBE is likely to have been achieved through earnings or expectations management. The findings also indicate that the premium to MBE is a leading indicator of future performance. This premium and its predictive ability are only marginally affected by whether the MBE is genuine or the result of earnings or expectations management.

Meeting or beating analysts’ forecasts of earnings is a notion well entrenched in today's corporate culture. From corporate boards’ deliberations to financial press reports and Internet chats, emphasis is placed on whether a company meets its earnings forecasts. The following comment typifies the view of the financial press regarding the importance of meeting Wall Street's expectations: In January, for the 41st time in 42 quarters since it went public, Microsoft reported earnings that meet or beat Wall Street estimates….This is what chief executives and chief financial officers dream of: quarter after blessed quarter of not disappointing Wall Street. Sure, they dream about other things…But the simplest, most visible, most merciless measure of corporate success in the 1990s has become this one: Did you make your earnings last quarter? (see Fox, 1997, p. 77). The importance assigned to meeting earnings expectations is not surprising given the valuation relevance of earnings information. Recent anecdotal evidence, however, suggests that companies are not merely passive observers in the game of meeting or beating contemporaneous analysts’ expectations (hereafter referred to as MBE). Rather, they are active players who try to win the game by altering reported earnings or managing analysts’ expectations (see for example McGee, 1997; Vickers, 1999). The motivations often suggested for such a behavior are to maximize the share price, to boost management's credibility for being able to meet the expectations of the company's constituents (e.g., stockholders and creditors), and to avoid litigation costs that could potentially be triggered by unfavorable earnings surprises. In this paper, we test whether, after controlling for the earnings forecast error for the period, there is a market premium to firms that MBE formed just prior to the release of quarterly earnings. Note that finding a premium to firms that meet or beat market expectations, after controlling for the earnings forecast error for the period, is quite distinct from the well-established finding in the literature of a positive relation between earnings and stock returns first documented by Ball and Brown (1968). For a premium to MBE to exist, the return over the period must be a function of not only unexpected earnings for the period (measured relative to the expectations held at the beginning of the period) but also the manner by which earnings expectations changed over the period, or the expectation path. This point is further discussed in Section 3. Exploring the MBE phenomenon further, we examine the extent to which the data on earnings forecast revisions and earnings surprises are consistent with expectations management or earnings management. Expectations management takes place whenever management purposefully dampens analysts’ earnings forecasts to produce a positive earnings surprise (or avoid a negative earnings surprise) upon the earnings release. Earnings management generally involves using accrual accounting in order to produce earnings that surpass the forecasted earnings target. In the cases where earnings or expectations are likely to have been managed, we examine whether the premium to MBE still exists. Finally, various explanations for the potential payoffs from an MBE strategy are explored that are consistent with investor rationality. Based on a sample of nearly 130,000 quarterly earnings forecasts made between the years 1983 and 1997 and covering approximately 65,000 firm-quarters, we find that, in line with previous research, instances in which companies meet or beat contemporaneous analysts’ estimates have increased considerably in recent years. The trend is common to all quarterly reporting periods and is also present in the annual period. It is observed for both large and small firms. On average, analysts’ forecasts made at the beginning of the period overestimate earnings (see similar findings by Barefield and Comiskey, 1975; Brown, 1997; Richardson et al., 1999, among others). However as the end of the reporting period approaches, analysts’ optimism (i.e., their overestimation of earnings) turns, as evidenced by the predominance of downward revisions in earnings estimates, into pessimism (i.e., underestimation of earnings). Further, the proportion of negative forecast error cases (measured relative to analysts’ earnings forecasts made at the beginning of the quarter) that ends with a zero or positive earnings surprise (measured relative to the most recent analysts’ earnings estimate) is greater than the proportion of positive or zero forecast error cases that ends with a negative surprise. These findings are consistent with expectations management taking place late in the reporting period. Our primary findings show that investors reward firms whose earnings meet or beat analysts’ estimates. After controlling for the quarterly forecast error (measured relative to analysts’ earnings forecasts made at the beginning of the quarter), the quarter's abnormal returns are positively and significantly associated with the earnings surprise for the quarter (measured as the difference between reported earnings and the most recent earnings estimate at the time of the earnings announcement). The average return over quarters ending with a positive earnings surprise is significantly higher, by about 3.2%, than the return over quarters that have the same overall quarterly earnings forecast error but end with a negative earnings surprise. These results suggest that, independent of the firm's absolute performance, there is a reward to meeting or beating analysts’ earnings expectation and a penalty for failing to do so. Ending the period “with a bang” (i.e., with a positive earnings surprise) results in a stock valuation that cannot be explained by the absolute level of the firm's performance. The results of a premium to MBE are unlikely to be driven by investors’ overreaction to good news (see, for example, Zarowin, 1989; DeBondt and Thaler, 1990). Such overreaction, if present, should lead to subsequent market reversals of the abnormal returns generated by the earnings surprise. Yet our tests based on an examination of abnormal returns over both a short window (consisting of the following quarter) and longer windows (up to three years following the earnings announcement) do not detect such a reversal. The premium to earnings surprises appears to be justified on economic grounds: Earnings surprises apparently possess information content with respect to future earnings as evidenced by the positive association between earnings surprises and future firm performance. While the reasons underlying this association are not investigated here, its presence suggests that investors rationally react to earnings surprises. We further find that earnings surprises that are likely to have been obtained through earnings or expectations management are associated with only a slightly lower premium and have marginally weaker predictive power with respect to future earnings. The paper is organized as follows. The next section reviews the recent research on the issue of MBE. Section 3 presents the empirical design, followed by a description of the sample and the data in Section 4. Results are provided in the following sections. The paper concludes with a short summary and suggestions for future research.

The paper examines the recent phenomenon of the “expectation game” whereby companies and investors focus on the degree to which reported earnings meet or beat analysts’ estimates. Anecdotal and empirical evidence, including findings provided by this paper, suggest that firms have become more successful in MBE and that this success is achieved in part by managing expectations. The evidence further shows that, after controlling for the absolute earnings performance, firms that manage to meet or beat their earnings expectations, even at the expense of an earlier dampening of those expectations, enjoy a higher return than their peers that fail to do so. While investors appear to apply some discount to MBE cases that are likely to result from expectations or earnings management, the discount is small and not significant economically. The finding of a premium to MBE, while explaining firms’ incentive to MBE, raises questions about investor rationality. However, the reward to MBE may be justified on economic grounds since earnings surprises appear to be a reliable predictor of the firms’ future performance. After controlling for the contemporaneous earnings performance, firms whose quarterly earnings releases constitute a favorable surprise show, in subsequent years, a higher growth in sales and earnings and a higher ROA and ROE than firms with the same earnings performance but with unfavorable earnings surprises. Like the premium to MBE, the predictive ability of MBE with respect to future firm performance depends only marginally on whether the MBE is genuine or whether it is produced through earnings or expectations management. The paper's findings leave some unanswered questions, the first of which is why analysts do not correct their forecasts for what appears to be a systematic downward bias in their late-in-the-period forecasts. Or, to put it in more concrete terms, how could analysts continue to underestimate Microsoft's quarterly earnings 41 times in a row? Examination of the characteristics of “habitual beaters” of earnings forecasts may shed light on this question. Another question that merits further examination is why MBE appears to have predictive ability with respect to firms’ future performance.