A Guide for Turbulent Times

Companies reveal more than their own profitability when they issue earnings announcements. They also provide clues about peer firms through a process called information transfer. New research from the University of Maryland’s Robert H. Smith School of Business confirms the spillover effect but also shows that more insights may be gleaned than previously understood.

“The nature of the information being transferred extends beyond quarterly profits,” says Rebecca Hann, KPMG Term Professor at Maryland Smith and co-author of the research in Review of Accounting Studies. “Earnings statements may also resolve questions about risk and uncertainty at peer firms.”

Her paper, written with Smith PhD alumni Heedong Kim and Yue Zheng, shows stronger information transfer when an earnings report come from a bellwether firm within the industry. “If an industry leader like Apple has negative earnings news, it’s probably bad news for others in the mobile market,” Hann says.

The effect is also heightened, in terms of resolving questions about risk and uncertainty, during periods of macroeconomic turbulence that cut across entire industries. Data privacy concerns, for example, impact all social media companies and not just Facebook. “How much Facebook is affected by that can tell us how other firms could be affected,” Hann says.

Another example would be Walmart’s response following Amazon’s acquisition of Whole Foods. “If there is an Amazon effect on Walmart, there could be an Amazon effect on other retailers,” Hann says. “An earnings report from Walmart during this period of uncertainty could help resolve questions industrywide.”

To measure the transfer of information about risk and uncertainty, Hann and her co-authors had to expand the scope of prior accounting research.

Past studies have focused on the stock price reaction to peer firms’ earnings announcements. “When a firm announces earnings, its investors react to the news, but so do the investors of its peer firms," Hann says. "We observe similar changes in their stock prices, which provides evidence of first-moment information transfer."

Hann and her co-authors looked beyond the first moment and focused instead on the standard deviation or "second moment" of stock returns. "We focus on the volatility of stock returns," Hann says. "The higher the volatility we observe, the greater the uncertainty."

What can investors learn by considering the different "moments" of an earnings announcement? A relatively narrow distribution in earnings forecasts signals high confidence in an earnings estimate, while a wide distribution signals the opposite.

"When there’s more uncertainty about a firm’s fundamentals — when there is greater uncertainty about its future cash flow — then their stock prices tend to be more volatile,” Hann says. "An earnings announcement tells us how profitable a firm is, but it also tells us how much uncertainty the firm’s industry faces, and hence it helps us assess the risk of its peers.”

Read more: “Intra-industry Information Transfers: Evidence from Changes in Implied Volatility around Earnings Announcements” with Heedong Kim and Yue Zheng, forthcoming at Review of Accounting Studies.