Price momentum and the premium for meeting or beating analysts' forecasts of earnings

Abstract

This study provides a theoretical rationale and empirical support that relates the existence and magnitude of the premium for meeting/beating analysts' EPS forecasts to the existence of preannouncement price momentum. The study is based on the theoretical work that suggests that extreme levels of price momentum can cause security prices to deviate from fundamental values even in the presence of well-informed and well-financed rational arbitrageurs. Differences of opinion regarding the extent of mispricing and/or optimal exit time to exit the position allow this mispricing to persist (Abreu and Brunnermeir 2002, 2003). To correct mispricing, a news event, like an earnings announcement, is necessary to synchronize investors' exit strategy beliefs (Abreu and Brunnermeir 2002, 2003). In the case of an earnings announcement, this synchronization of beliefs triggers a price reaction of such magnitude that it cannot be explained by unexpected earnings. Instead, we hypothesize and show that the abnormal price reaction is largely captured in what empirical researchers have identified as the meet/beat market premium. Our findings provide a cohesive argument for the temporal variation in meet/beat premiums documented by Koh, Matsumoto and Rajgopal (2008).