Evidence of Informational Asymmetries from Management Earnings Forecasts and Stock Returns.

Abstract ABSTRACT: This paper compares the information investors have about a firm's future earnings, as reflected in its stock price, to that of the firm's management, as reflected in its management earnings forecast. Stock returns in the preforecast and forecast announcement period are positively associated with management earnings forecast errors, indicating that stock prices contain information beyond that reflected in management forecasts. This phenomenon can occur if management does not issue its true forecast or if investors have information about earnings that management does not have. The first hypothesis, that management forecasts do not fully reflect management's information, implies that forecasts will be biased in a directional or nondirectional manner. This study conducts tests for directional bias and develops and conducts a test for nondirectional bias, using a sample of management forecasts occurring in years 1979-1983. The hypothesis that management forecasts are biased is only rejected for forecasts made in 1982. Given the magnitude of economic changes occurring in 1982, post-forecast information may well have been negative, causing the average forecast error in 1982 to differ from zero. In the other years studied, the hypothesis that management forecasts are biased is not rejected. The data, thus, suggest that stock prices reflect information beyond that in management earnings forecasts because investors access some information that managers do not.