Sentiment, Loss Firms, and Investor Expectations of Future Earnings

Abstract

This study investigates the mispricing of market-wide investor sentiment by exploring the relation between sentiment and investor expectations of future earnings. Prior research argues that sentiment-driven mispricing should be most pronounced for hard-to-value firms, such as those reporting losses (Baker and Wurgler 2006). Using investor expectations of future earnings, we provide empirical results consistent with this behavioral finance theory. We predict and find that investors perceive losses to be more (less) persistent during periods of low (high) sentiment; that (in contrast) investors perceive profit persistence to be lower (higher) during periods of low (high) sentiment; and that the effects appear stronger for loss firms relative to profit firms. We also document predictable cross-sectional variation within losses, with the mispricing mitigated for losses associated with activities expected to generate future benefits: R&D, growth, large negative special items, and severe financial distress. Overall, our results document a new and important channel—investor expectations of future earnings—to explain sentiment-driven mispricing.