Earnings announcements are the primary mechanism through which public companies provide periodic financial performance updates to investors. It is, therefore, not surprising that a considerable body of academic research examines the relation between stock prices and earnings announcement premium. Beaver (1968) provides strong support for the hypothesis that earnings announcements convey information to investors. In the US, publicly listed firms have been required to file detailed quarterly income statements with the SEC on Form 10-Q since 1970. Most companies also announce earnings to investors ahead of their Form 10-Q filing through voluntary earnings announcements. The information provided in these voluntary earnings announcements varies widely and ranges from a brief summary of bottom-line earnings to a detailed set of financial statements. Much of the early literature concludes that it takes a period ranging from 6 to 12 months for earnings information to be fully reflected in stock prices (e.g., Bernard and Thomas, 1989; Abarbanell and Bushee, 1998).
Post-earnings announcement drift (PEAD) is a phenomenon where stock prices tend to drift upward (downward) after the earnings announcement if the earnings are unexpectedly positive (negative). This earnings drift constitutes a violation of stock market efficiency and attempts to explain this phenomenon as an artefact of omitted risk factors, mismeasured returns, or research design flaws have been only partially successful. The PEAD strategy can be implemented by buying the decile of firms with the most extreme positive earnings surprises and shorting the decile of firms with the most extreme negative earnings surprises. The decile portfolios are formed based on quarterly earnings surprises and are rebalanced quarterly. Post earnings announcement drift still persists even after controlling for price momentum effect Chan et al. (1996).
Brandt et al. (2008) study the drift in returns of portfolios formed on the basis of the stock price reaction around earnings announcements. They find abnormal returns of about 12.5% per annum using Earnings Announcement Return (EAR) and (Standardized unexpected earnings) SUE strategies. Moreover, Liu, Strong, and Xu (2003) examine UK data and find evidence of significant post–earnings–announcement drift, robust to alternative controls for risk and market microstructure effects.
PEAD has been found to be caused by under-reaction. This has been attributed to behavioural biases (e.g., Barberis, Shleifer and Vishny, 1998; Daniel, Hirshleifer and Subrahmanyam, 1998), the disposition effect (e.g., Frazzini (2006), the bounded rationality of and interaction between heterogeneous investor types (e.g., Hong and Stein, 1999), risk (e.g., Fama, 1998), and liquidity (e.g., Chordia, Goyal, Sadka and Shivakumar, 2009).
It has also been documented that announcement of an extremely high or low (SUE) is likely to lead to market overreaction. Ertan, Karolyi, Kelly, and Stoumbos (2015) show that past earnings announcement returns are a determining factor of individuals’ investing decisions in the period leading up to the next earnings announcement. Bai and Qin (2015) document a price reversal following earnings announcements for firms reporting negative earnings surprises. They attribute their findings to a possible investor overreaction to a negative earnings signal on the day of the earnings announcement.
Other research attributes a market overreaction to heterogeneous agents (e.g., Hong and Stein, 1999), overconfidence and biased self-attribution (e.g., Daniel, et al. 1998), high-frequency trading (e.g., Zhang, 2010), and those announcements with greater salience (e.g., Huang, Nekrasov and Teoh, 2013).
In conclusion, the PEAD phenomenon is strongly documented and unlikely to disappear. Arbitrage risk has been found to be statistically and economically significant, preventing PEAD to be arbitraged away (Mendenhall, 2004). However, PEAD is shown to be more significant for small-cap firms but not for the announcements of large firms which may suggest some of the profits come from liquidity premium. They can disappear after accounting for trading costs (Bernard and Thomas, 1989). PEAD profits may also be simply rewards for taking on risk as volatility is shown to be much higher around the announcement period.
