Investors and analysts look to a company’s management forecasts to predict upcoming earnings announcements and decide whether to buy or sell its stock. Once earnings are actually reported, those forecasts become useless. Or do they?
New research from the University of Maryland’s Robert H. Smith School of Business, forthcoming in The Accounting Review, finds that management forecasts – in particular, the parts that are wrong – may contain predictive information about future earnings even after actual earnings for the forecasted period are announced.
Maryland Smith accounting professor Michael Kimbrough, along with former Smith professor Hanna Lee and Yue Zheng, PhD ’17, now at the Hong Kong University of Science and Technology, looked at 14,449 annual management forecasts from 1995 to 2016, specifically at the errors in those forecasts. They find new evidence that a significant portion of those management forecasting errors (MFEs) are predictive of future earnings.
The researchers identify three reasons why managers could make errors: Their timing could be off, they could be intentionally biasing the forecasts before buying or selling stock, or they could just be bad at forecasting.
To illustrate a timing mistake, the researchers use the example of a pharmaceutical company with a new drug on the horizon, where the company’s management forecast accounts for FDA approval and sales. If the approval gets held up, the anticipated sales won’t materialize in the forecasted earnings period, leading to an optimistic error (when forecasted earnings exceed realized earnings). The error will be predictive of future earnings if the FDA eventually approves the drug and anticipated sales ultimately occur. In this case, although managers are wrong about the timing of the anticipated sales, they are right about their ultimate realization. However, the error will not be predictive of future earnings if the FDA ultimately doesn’t approve the drug because the anticipated sales will never be realized. The researchers’ finding that errors are predictive of future earnings indicates that many errors are the result of timing mistakes and can still be valuable tools.
“Traditionally, MFEs are viewed as backward-looking measures of how well management forecasts preempted earnings announcements, but not as sources of forward-looking information,” write the researchers. “We show that when managers are premature in their anticipation of economic events but are correct about their ultimate realization, MFEs are informative about earnings beyond the forecast period.”
The results are largely attributable to optimistic errors. Pessimistic errors tend not to be informative because they are more likely to reflect expectations management, the researchers say.
Investors and others can benefit from correctly assessing the likelihood that an observed error is merely a timing mistake. The researchers show that, although higher ability managers tend to make fewer errors, their errors tend to be more predictive of future earnings. Stated alternatively, higher ability managers’ expectations tend to be borne out in the long run.
The researchers say distinctions should be made among managers who make forecasting errors. “Specifically, managers who make errors that are eventually realized have more sound long-run expectations than managers who make errors that are never realized and should thus be viewed as more credible and knowledgeable about their businesses,” they write.
The findings are of particular interest to analysts and investors, who can use this additional predictive information to make more money. Analysts can improve their forecast accuracy by incorporating optimistic management forecasting errors into their own forecasts. But the same is not the case for pessimistic management forecast errors because those mistakes are largely the result of managers’ biases and inabilities.
Those who use management forecasts to assess managers should also take note, say the researchers. Inaccurate management forecasts have often raised doubts about a manager’s credibility or ability, but these doubts should be less severe for forecast errors with predictive information because those errors are temporary, they say.
“Thus, interested stakeholders should consider the nature of such errors when determining the most appropriate reputational and labor market penalties for inaccurate forecasts,” write the researchers.
Read the full research, “Can Managers be Wrong and Still be Right? An Examination of the Future Realization of Current Management Forecast Error,” forthcoming in The Accounting Review.
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