The Market’s Reaction to Changes in PerformanceRankings
Jared Jennings
Olin School of Business
Washington University
Hojun Seo
Olin School of Business
Washington University
Mark T. Soliman
Marshall School of Business
University of Southern California
June 1, 2014
Abstract:
We examine how investors value changes in the relative performance ranking of the firmwithin the industry. We argue that the relative performance of the firm conveys information about the ability for the firm to compete in the industry. We find that investors positively (negatively) value increases (decrease) in the firm’s performance ranking, especially when the firm is initially estimated to be a low performer in the industry and when the change in the firm’s performance ranking has been stable in the past.Since the market seems to value increases in the firm’s performance ranking, we also predict and find evidence consistent with managers opportunistically excluding expenses from non-GAAP earnings to increase the firm’s performance ranking. We find that investors discount an increase in the firm’s performance ranking when it is more likely that managers are opportunistically excluding expenses from non-GAAP earnings to improve the relative performance of the firm.
MARK – WE HAVE THOUGHT ABOUT CALLING THE CHANGE IN THE PERFORMANCE RANKING A RANKING SURPRISE, SINCE THAT IS WHAT IT REALLY IS. WE DID NOT KNOW IF WE WOULD GET INTO TO MUCH TROUBLE BY DOING THAT.
1.Introduction
A lucid benchmarkthat investors use to assess the firm’s performance is analyst expectations (Graham, Harvey, and Rajgopal, 2005). The financial press commonly compares the firm’s announced earnings to what analysts and other market participants expect. Not surprisingly, the prior literature has primarily focused on the benefits that a firm experienceswhen meeting or beating analyst expectations. For example,Kasznik and McNichols (2002) and Fischer, Jennings, and Soliman (2014) provide both empirical and theoretical evidence that firms meeting or beating expectations have higher returns and stock prices than firms that do not. However, the firm’s performance relative to analyst expectations is not the only benchmark that investors use to assess the firm’s performance.Market participants oftencompare the performanceof the firm withthat of other firms in the same industry.[1] In this paper, we examine how investors value a change in the firm’s performance ranking within the industry. By doing so, we hope to better understand what information is communicated through earnings to the capital markets as well asthe types of benchmarks investors use to evaluate the firm’s performance. In addition, we examine whether managers opportunistically manage earnings to affect the firm’s performance ranking and whether the market reacts less to a change in the firm’s ranking when managers are more likely to beopportunistically managing earnings.
A firm’ performance can be decomposed into a firm-specific and non-firm-specific component (e.g., Waring, 1996; Rumelt 1991; McGahan and Porter 2002).[2]The non-firm-specific component of the firm’s performanceis affected by industry or market level shocksthat affect all firms in the industry or market. The non-firm-specific component of the firm’s performance is likely to be primarily useful in evaluating the overall health of the industry or market. However, the component of performance that has a largest influence on the firm’s overallperformance is the firm-specific component, which is the primary source for intra-industry heterogeneity (e.g., Rumelt, 1991; McGahan and Porter, 2002). Thus, the firm-specific component of firm performance is useful in evaluating the firm’s performanceand competitive advantage within the industry and market (Nelson, 1991).If the competitive advantages of the firmare not readily substituted or imitated by rivals, then a change in the firm’s competitive advantage is expected to reflect an increase to expected future shareholder profits (e.g., Peteraf, 1993).
We attempt to measure how investors valueameaningful change in the firm-specific component of performanceby examining changes in the firm’s performance ranking within its industry. Sloan (1996) provides evidence that earnings typically exhibit high serial correlation year over year, suggesting that innovations to earnings are likely to persist. Therefore, we argue that the change in the firm’s performanceranking within the industry is likely to be a significant and potentially persistent change to the expected future performance and competiveness of the firm within the industry. Therefore, we anticipate that a change in the performance ranking of the firm within the industry is a significant information event, which ultimately conveys information to investors about the firm’s ability to generate profits for its shareholders.
Using a sample of 142,581 firm/quarter observations from 1997 to 2012, we examine whether investors positively value an improvement in the firm’s performance ranking within the industry. To calculate changes in the firm’s performance ranking, we compare an initial ranking of the firm’s performancebased on analyst expectationsto the realized ranking of the firm’s performance based on realized earnings.[3],[4]Consistent with expectations, we find that the change in the firm’s performance ranking is positively associated with buy-and-hold abnormal returns during the three-day window surrounding the earnings announcement, after controlling for the firm’s earnings surprise and other firm characteristics. In fact, the positive market reaction to an increase in the firm’s performance ranking within the industry is approximately 55% of the market’s reaction to the firm’s earnings surprise.This evidence suggests that investors use both the earnings surprise as well as the relative performance of the firm within the industry to assess the firm’s ability to generate profits for shareholders.
Next, we examine whether the market’s reaction to the change in the firm’s performance ranking varies based onthe initial ranking of the firm’s performance in the industry. We anticipate that investors react more (less) to changes in the firm’s performance ranking when the firm is initially evaluated as a lower (higher) performer in the industry. If lower performers are unable to produce sufficient profits or toobtain the necessary capital needed to continue operating withinthe industry, lower performers are more likely to enter into bankruptcy or exit the market as more efficient firms enter the market. As the likelihood of bankruptcy or exiting the market increases, investors may be expecting the low performing firm’s profits to erodein the relative short runand/or may be shorteningthe time-series of expected future cash flows, causing the stock price to decrease. Therefore, the expected future cash flows of lower performers are likely to be more sensitive to changes in the firm’s relative performance in the industry. Consistent with expectations, we find that the market reaction to the change in the firm’s performance ranking is approximately 103% (18%) of the market’s reaction to a similar increase in the earnings surprise when the firm is initially evaluated as a low (high) performer.
We also examine whether the past stability of the firm’s performance ranking changes affects investors’ market reaction to a change in the performance ranking of the firm. As previously mentioned, we argue that a change in the firm’s performance within the industry is reflective of a change to the expected future performance and competiveness of the firm within the industry. If thefirm-specific component of performance has been stable (volatile) in the past, the change in the firm’s performance ranking in the current period is more (less) likely to provide an informative signal about the change in the future expected performance or competitiveness of the firm in the industry. Consistent with our prediction,we find that investors’ reaction to a change in the performance ranking of the firm is greatest (lowest) when the firm’s past ranking changes have been stable (volatile) over the preceding three years. The market reaction to the change in the firm’s performance rankingis approximately 83% (32%) ofthe market’s reaction to the firm’s earnings surprise when the past ranking changes have been stable (volatile).
In 1998, Arthur Levitt, former SEC commissioner,expressed concern that firms were using earnings management to meet or beat analyst expectations.[5] Since then, several papers have examined how managers might influence analyst expectationsor manipulate earnings to opportunistically exceed analyst expectations. The prior literature has provided evidence consistent with managers using accrual manipulation (e.g., Abarbanell and Lehavy, 2003; Burgstahler and Eames, 2006), expectations management (e.g., Matusmoto, 2002), real activities manipulation (e.g., Roychowdhury, 2006), and non-GAAP earnings manipulation (e.g., Doyle, Jennings, and Soliman, 2013)to opportunistically exceed analyst expectations. Therefore, if the firm’s performance ranking is an important measure used by investors to evaluate firm performance, we anticipate that firms also have the incentive to opportunistically manipulate their performance ranking within the industry.
Since changes in the firm’s performance ranking can change each time a firm in the industry announces earnings (which may occur frequently during the quarter), managers are likely unable to utilize many of the previously documented earnings management tools due to potentially sudden changes in the firm’s performance rankingas other firms in the industry announces earnings. As a result, we focus on the opportunistic exclusion of expenses from non-GAAP earnings (e.g., Doyle et al., 2003; Bowen et al., 2005; Doyle et al., 2013) to examine whether managers are opportunistically manipulating the firm’s performance ranking. The opportunistic exclusion of expenses from non-GAAP earnings does not require journal entries, a change in the operations of the firm, or extensive justification for excluding expenses with the auditor. We find evidence consistent with managers excluding expenses from non-GAAP earnings to improve the firm’s performance ranking within the industry. Our results appear to be driven by the more opportunistic excluded expenses (i.e., other exclusions), as documented in Doyle et al. (2013).[6]We also find evidence that investors’ positive reaction to the improvement in the firm’s performance ranking issignificantly reduced when the exclusions are more likely to be opportunistic. Specifically, we find that the positive market reaction to an improvement in the firm’s performance ranking that is coupled with the exclusion of expenses is muted when the firm is initially evaluated as a low performer, which is when investors react more strongly to changes in the firm’s performance ranking.
In each of our tests described above, we control for firm size, firm growth, the magnitude of the earnings surprise, accruals, the firm’s initial ranking within the industry, and the volatility of the firm’s ranking changes within the industry over the past three years. In addition, we include industry-quarter fixed effects to captureunobservable time-varyingindustry characteristics (e.g., industry-level entry barriers or product market competition). We also cluster standard errors by firm and time (Peterson, 2009; Gow et al., 2013).In additional robustness tests, we explicitly control for changes in the consensus analyst recommendation and find that all of our aforementioned results are qualitatively and quantitatively similar. This is an important robustness test because prior studies find that changes in analyst recommendations may be associated with changes in the firm’s relative performance within the industry (e.g., Stickel 1985), and thus, the abnormal returns surrounding the earnings announcement could possibly be attributed to the changes in analyst recommendations rather than the changes in the firm’s performance ranking. By explicitly controlling for change in the consensus analyst recommendation, we rule out this possibility.
We believe that this paper contributes to the literature in three key ways. First, we document another benchmark that investors use to evaluate the firms’ performance – the relative ranking of the firm’s performance within the industry. Put differently, our study suggests that investors evaluate the firm’s performance based on the entire distribution of earnings in a given industry to shed additional light on the competitive position of the firm within the industry. The prior literature, however, has primarily focused on the costs and benefits of meeting or beating analyst expectations (e.g., Degeorge et al., 1999; Matsumoto, 2002; Skinner and Sloan, 2002; Fischer et al, 2014), increasing earnings from the last period (e.g., Burgstahler and Dichev, 1997; Degeorge et al., 1999), or reporting earnings greater than zero (e.g., Burgstahler and Dichev, 1997). We extend the prior literature by showing that there are other important benchmarksthat investors use to evaluate the firm’s performance. Earnings appear to convey useful information to investors about unexpected earnings innovations as well as changes in the firm’s competitive position within the industry.
Second, we find that the opportunistic use of positive exclusions is not limited to meeting or beating analyst expectations but also manipulating the relative ranking of the firm within the industry. The vast majority of the extant literature seems to focus on management manipulating earnings to meet or beat the analysts’ consensus forecast (Doyle et al., 2013), increase earnings from the prior period (Burgstahler and Dichev, 1997; Degeorge et al., 1999), or avoid negative earnings (Burgstahler and Dichev, 1997). The prior literature pays little attention to firms that are well above or below these specific benchmarks. We provide evidence that managers have incentives to manipulate earnings even though they may be comfortably below or above these specific benchmarks.
Third, our study extends the concept of relative performance evaluation (RPE) to stock valuation by providing initial evidence of RPE in capital markets. Both theoretical and empirical RPE has been mainly studied in the contracting literature. For example, RPE theory predicts that a principal evaluatesan agent based on idiosyncratic performance after filtering out external shocks to improve contracting efficiency (Holmstrom, 1982).Milgrom and Roberts (1992) argue that information about the relative and ordinal performance is the most useful information in a tournament setting in an organization. Consistent with this, the prior empirical RPE studies analyze firms’ proxy statements and finds that a majority of firms compensate CEOs based on the changes in the firm’s performance ranking (e.g., Murphy, 1999; Carter et al., 2009; Bannister et al., 2011; De Angelis and Grinstein, 2014).In this paper, we document that RPE is not restricted to the contracting setting by showing that outside investors also evaluate firm performance based on the change in the firm’s performance ranking and adjust stock prices accordingly.[7]
In the next section, we develop our hypotheses. In Section 3, we describe our empirical tests. We discuss our results in Section 4. We discuss the results from additional robustness tests in Section 5. We conclude our study in Section 6.
2. Hypothesis Development
Analyst expectations are a widely used benchmark used to assess the performance of the firm. The financial media routinely cites analyst expectations when reporting the firm’s performance as a relevant benchmark in comparing expected performance to actual performance. When the actual performance of the firm is higher than expectations, firms typically experience positive abnormal returns. Kasznik and McNichols (2002) provide empirical evidence that firms that meet or beat analyst expectations experience a positive return premium on their stock. Fischer et al. (2014) provide theoretical and empirical evidence that a rational pricing bubble forms as the number of consecutive quarters that meet or beat analyst expectations increases. Therefore, meeting or beating expectations appears to positively affect the stock price of the firm, increasing management’s incentives to meet or beat analyst expectations. Consistent with this, in a survey of firm executives, Graham, Harvey, and Rajgopal (2005) find that 74% of firm executives believe that the analysts’ expectation is an important benchmark when reporting earnings.
However, meeting or beating analyst expectations is likely not the only benchmark that market participantsuse to assess the performance of the firm. Analysts and journalistscommonly evaluate the performance of the firm relative to other firms that are in the same industry (e.g., Boni and Womack, 2006; Kadan et al., 2012; Calia, 2014; Roger, 2013; Orlick, 2012).Analysts tend to incorporate firm rankings into recommendations; however, other firm, industry, and market factors also heavily influence these recommendations.The media also compares the performance of a firm to the performance of other firms in the industry. Despite the above, there has been little empirical evidence on how investors react to changes in the relative performance ranking of the firm. To the best of our knowledge, Graham et al. (2005) do not ask corporate executives as to whether the firm’s performance ranking within the industry is an important benchmark to firm executives. The absence of this question could be due to the focus of the extant accounting and finance literature on meeting or beating analyst expectations, avoiding losses, and reporting positive increases in earnings. Therefore, we do not currently have much evidence on the relative importance of the change in the firm’s performance ranking in the industry.
Rumelt(1991) decomposes overall firm performance into three components: 1) the overall business cycle component, 2) the industry component, and 3) the business-specific component. Rumelt (1991)documents that the firm-specific componentof performance is the most significant driver of the firm’s overall performance. He argues that the firm-specific component of performance is mainly determined by “the presence of business-specific skills, resources, reputations, learning, patents, and other intangible contributions to stable differences among business-unit returns.”McGahan and Porter (2002) analyze the variance of accounting profitability and also find consistent evidence that the firm-specific component of performance has a largest influence onoverall firm performance.Waring (1996) finds that the persistence of the firm-specific component of performance substantially varies across different industries and documents that variables such as the percentage of professional workers, the degree of unionization, the percentage of consumer purchases, the number of firms within the industry, economies of scale, and R&D intensity have strong influences on the persistence of the firm-specific component of performance. Overall, prior research argues that the firm-specific component of performance is a significant predictor of the firm’s overall profitability.
Based on the above discussions, we anticipate that investors primarily evaluate the firm using the firm-specific component of performance, which allows investors to better understand the relative competitive advantages held by the firm in the market and industry.If rivals cannot easily imitate the competitive advantages held by the firm, thenthese competitive advantages are expected to be sustained, allowing the firm to generate greater returns for shareholders (e.g., Peteraf, 1993; Barney 1986; Barney 1991).In addition, Sloan (1996) provides evidence that firm performance is likely to exhibit high serial correlation year over year, suggesting that innovations to a firm’s performance is likely to persist. Therefore, the change in the firm-specific component of performance that moves the firm’s competitive position within the industry ultimately conveys information to investors about the firm’s ability to continue as a going concern and the firm’s ability to generate profits for its shareholders.