Credibility of Management Earnings Forecasts and Future Returns

This study investigates the effect of managerial discretion over their initial earnings forecasts on future performance. First, by estimating the discretionary portion of initial management earnings forecasts (defined as discretionary forecasts) based on the findings of fundamental analysis research, we find that firms with higher discretionary forecasts are more likely to miss their earnings forecast at the end of the fiscal year and revise their forecasts downward to meet their earnings forecasts for the period, suggesting that forecast management through discretionary forecasting produces less credible management forecasts in terms of ex-post realization. Second, by using the hedge-portfolio test and regression analysis, we find that firms with higher discretionary forecasts earn consistently negative abnormal returns, suggesting that investors do not fully understand the implication of discretionary forecasts for the credibility of management earnings forecasts and thus overprice them at the forecast announcement.