06 Financial Accounting 1: Financial analysts/equity valuation (FAR1)

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    Diversity, Information Choice, and Aggregate Market Outcomes
    ( 2022) Zhang, Shiyi ; Kumar, Alok ; Chhaochharia, Vidhi
    This study examines whether racial/ethnic diversity among market participants is associated with diverse information environments and better aggregation of information. Using measures of diversity among sell-side equity analysts, we demonstrate that although minority analyst forecasts are less accurate, their forecasts are more consistent, and they employ richer information sets. At the aggregate level, earnings are more predictable when the consensus is based on a larger proportion of minority forecasts. The predictive ability of minority analysts is stronger when corporate boards are more diverse, and market uncertainty is high. Further, the stock market reaction following an earnings announcement is stronger when the consensus uses inputs from more diverse analysts. Collectively, these results suggest that greater diversity among equity analysts is associated with better information environments and more efficient stock prices.
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    Analyst Monitoring of Opportunistic Firm Behavior
    ( 2022) Godwin, Thomas ; Goodman, Theodore ; Muslu, Volkan
    Prior literature presents mixed evidence about analyst monitoring of opportunistic firm behavior. We find that analysts reduce annual earnings forecasts as well as target prices around earnings announcements of the first three quarters of the fiscal year as if they punish a firm’s accrual-based and real earnings management during the quarters. The forecast reductions are more pronounced when analysts have less conflicts of interest with the firm (i.e., when analysts are employed by smaller brokers and when they are less experienced) and when analysts are less influential and less accurate. We also find that the firm responds to analyst monitoring by reversing its opportunistic behavior during the subsequent quarter. The reversals are more pronounced when the firm relies more on analyst optimism (i.e., when the firm has a lower market capitalization, higher market-to-book ratio and greater use of external financing). Collectively, our findings shed light on the dynamics of analyst monitoring by documenting sequential actions of analysts and the firm after the firm’s opportunistic behavior.
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    Linguistic Mirroring and Executive Responses: Evidence from Earnings Conference Calls
    ( 2022) Brightbill, Kathryn ; Small, Christopher ; Song, Jane
    Linguistic mirroring is a well-documented phenomenon that describes the imitation of the linguistic attributes of another party, including their words, phrases, and style. We examine how managers respond to analysts’ linguistic mirroring during conference calls and find that managers provide shorter, less complex, more numerical, and more analytical responses to analysts that exhibit higher degrees of linguistic mirroring. Linguistic mirroring is also associated with increased trading volume around the conference call, greater average analyst forecast accuracy, and lower analyst forecast dispersion in the subsequent quarter, consistent with mirroring providing information and generating analyst consensus. We also find evidence that analysts engage in mirroring strategically in response to information-gathering incentives. Our results are robust to using additional measures of mirroring and to alternative explanations. We conclude that linguistic mirroring is an important mechanism through which analysts gain information from managers, benefiting the firm’s information environment.
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    Emotional Media Content, Profitability Growth, and Long-term Return Reversals
    ( 2022) Taori, Peeyush ; Deuskar, Prachi ; Subramanyam, K.R.
    We distinguish textual tone—the balance of positive and negative words—with emotional versus factual content and posit that media tone only with emotional content represents investor sentiment. Consistent with this hypothesis, a High-Minus-Low portfolio formed on firm-specific media tone generates large negative three-year alphas of up to -18% when content is emotional but insignificant alphas when factual. The significant alphas arise only from the idiosyncratic component of media tone. The return reversal pattern synchronizes with reversals in profitability growth (ROE). Overall, emotional media tone captures overreaction to past profitability growth and subsequent correction of mispricing in the long run.
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    Do Designated Market Makers Facilitate Earnings News Discovery?
    ( 2022) Pan, Jing ; Ma, Lei ; Bhattacharya, Neil ; Chakrabarty, Bidisha
    Designated market makers (DMMs) are contractually obligated to increase liquidity provision when trading volume breaches a floor. Using this feature in a regression discontinuity design, we show that increased DMM participation facilitates price informativeness with respect to earnings news. Enhanced DMM participation is associated with greater informed trading, as evidenced by more short selling on negative news and more SEC EDGAR searches before earnings announcements. Our results highlight the value of obligatory liquidity provision during scheduled corporate events with high fundamental information flows.
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    Production Complementarity and Momentum Spillover Across Industries
    ( 2022) Lee, Charles M.C. ; Shi, Tianshuo ; Sun, Stephen Teng ; Zhang, Ran
    Economic theory suggests production complementarity is an important driver of sectoral co-movements and business cycle fluctuations. We operationalize this concept by developing a measure of the production complementarity distance (COMPL) between any two companies. We find firms from different industries that are closely aligned in terms of COMPL exhibit strong co-movement in both fundamentals and stock returns. Further, we find a strong lead-lag effect in returns, such that a long-short strategy based on recent COMPL peer returns yields a monthly alpha of 137 basis points, with no reversals. This inter-industry momentum effect is not explained by common risk factors or other network-based effects such as industry membership, customer-supplier relations, and shared analyst coverage. We conclude cross-industry news transfer occurs along complementarity networks, but stock prices do not update instantaneously.
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    Stock market participation and accounting information
    ( 2022) Anchev, Stefan ; Lapanan, Nicha
    We find empirical evidence suggesting that, over time, the increased stock market participation of investors has decreased the relevance of firms' accounting information. This negative relation is apparent primarily in the short term (i.e., over two consecutive quarters), unidirectionally Granger-causal, somewhat stronger after mid-1999, driven by transient and quasi-indexing investors and obtained after controlling for time trends, several potential risk factors and various stock market and economy characteristics. Together, these findings support the hypothesis that, due to an improvement in the risk sharing among investors, the increase in their stock market participation has weakened their incentives to process accounting information.
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    Why Has PEAD Declined Over Time? The Role of Signal Informativeness
    ( 2022) Kettell, Laura ; McInnis, John ; Zhao, Wuyang
    Post-earnings-announcement drift (PEAD) has declined significantly in recent decades, and perhaps disappeared. The prevailing explanation is that increased arbitraging activities have led to its attenuation. We propose a new explanation based on a decline in the informativeness of current earnings news in predicting future earnings news, which we label “signal informativeness.” We show that the signal informativeness of standardized unexpected earnings (SUE) has declined and significantly explains variation in PEAD over time. In fact, once we account for declining SUE signal informativeness, the downward trend in PEAD is no longer significant. The role of SUE signal informativeness in explaining declining PEAD survives when we control for several common proxies for arbitraging activities. Further, PEAD is still alive in recent years for firms with high predicted signal informativeness. Overall, we conclude that the declining signal informativeness of earnings news is a key driver behind the attenuation of PEAD.
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    Sell-Side Analysts’ Assessment of Operational Risk: Evidence from Negative ESG
    ( 2022) Park, Min ; Yoon, Aaron ; Zach, Tzachi
    Financial analysts closely follow a firm’s operations and assess the risks that it faces. Operational risks have value implications to firms, and as such are expected to be reflected in analysts’ outputs. In this paper, we examine whether analysts incorporate assessments of operational risks. We use firm-day level data from RepRisk about negative operational incidents that are classified into environmental, social, and/or governance issues. We find that analyst outputs predict negative ESG incidents, suggesting that analyst outputs contain information that is predictive of these events. Our results are robust to controlling for negative ESG incidents that firms experienced in the past, and are stronger in more transparent information environments, and in the presence of more guidance on ESG issues from Sustainability Accounting Standards Board. Finally, we find that these ESG risks are incorporated into analyst outputs through adjustments to discount rates rather than to cash flow estimates. Overall, our results highlight the ability of financial analysts to synthesize and integrate operational risks, and in particular ESG-related risks, into their research outputs.
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    Cross-sectional variations in the valuation role of investment growth
    ( 2022) Lim, Steve ; Irvine, Paul ; Kwon, Shin
    Real options models show a stepwise increase in the value-earnings association as accounting profitability increases and guides managerial investment decisions. However, we expect the role of investment growth in valuation to vary depending upon whether tangible or intangible investments support the investment growth. We find that value is less strongly associated with earnings when intangibles support investment growth. We attribute the differential value-earnings association across tangibles- vs. intangibles-supported investment growth to underinvestment in intangibles under the mandatory expensing accounting regime. We also find that the differential value-earnings association is increasing in financial constraints. We attribute this finding to the fact that financial constraints exacerbate the underinvestment problem by curtailing or delaying risky intangible investments. Lastly, we find that the differential value-earnings relation is limited to firms with low compensation convexity. We attribute this finding to the efficacy of managerial risk-taking incentives of compensation convexity because option vega helps mitigate the underinvestment problem by inducing executives to take up risky intangible investments. We contribute to the literature by documenting cross-sectional variations in the feedback role of accounting profitability.