Quarterly Earnings Forecasting Decisions by Family Firms and the Market Reaction to Them
We study the disclosure incentives for family firms by examining the characteristics of their quarterly earnings forecasts and analysts’ and investors’ responses to them. Forecasts offered before the fiscal quarter-end (guidance) by S&P 500 family firms are generally more specific and timely than those offered by S&P 500 non-family firms, particularly when they convey bad news or confirm analysts’ current expectations. Further, family firm guidance elicits a stronger response from both analysts and investors. While many of these differences largely disappear when the forecasts are offered after the quarter-end but before the earnings announcement itself (preannouncements), family firm preannouncements still tend to be more specific when they contain bad news. These more specific preannouncements also generate a significantly stronger response from analysts. Overall, our results suggest that large, visible family firms use manager-generated earnings forecasts to create a more transparent information environment, and that these forecasts are likely to be most useful in reducing information asymmetry and agency costs when they are issued as guidance.
Key Words: Management earnings forecasts, family firms, preannouncements, earnings warnings.
Data Availability: Data are available from the sources listed in the text.
Family firms are generally defined as companies that are significantly influenced by founding family members or their descendants, through large shareholdings and/or operational control.
Anderson and Reeb (2003a, 2003b) report that family members hold approximately 18% of the equity of the family firms in the S&P 500, on average, and control 45% of the CEO positions. In addition, family members often hold seats on the board of directors or are part of upper-level management in these firms (“Family Inc.”, Business Week, November 10, 2003). The structure inherent in these family firms gives rise to different agency problems than those in firms with much greater separation of ownership and control. Specifically, the family firm structure significantly limits the agency problems that arise from the separation of ownership and control (often referred to as Type I agency problems) while exacerbating those that arise in the conflict between controlling and non-controlling shareholders (often referred to as Type II agency problems, see Ali et al. 2007, Chen et al. 2007, Wang 2006 and Anderson and Reeb 2003a). It is well known that the second type of agency problem can be partially mitigated by frequent and transparent disclosure. However, it is also possible that reputational concerns may arise from the long-term nature of family members’ investment in their firm, mitigating this problem and reducing the need for more frequent and transparent disclosure (Wang 2006).
The purpose of this paper is to add to our understanding of these competing incentives for differential disclosure by examining the characteristics of quarterly earnings forecasts issued by the management of family firms and the response of sell-side analysts and investors to them. Recent accounting research that examines mandatory financial disclosures by family firms suggests that reputational concerns alone may not be sufficient: Characteristics of family firms’ mandatory financial reports are consistent with their being used to mitigate the agency problem between controlling and non-controlling shareholders. More specifically, Ali et al. (2007) and Wang (2006) show that large family firms offer higher quality financial reports as evidenced by lower discretionary accruals, greater ability of earnings to predict cash flows and larger earnings response coefficients. In addition, Ali et al. (2007) find that family firms in the S&P 500 are more likely to voluntarily issue earnings forecasts during periods of earnings declines. However, they also find that family firms are less forthcoming in their disclosures about corporate governance. In a paper that was written concurrently with ours, Chen et al. (2007) study the frequency of voluntary disclosures (earnings and non-earnings forecasts and conference calls) from a larger sample of firms that includes the S&P 500, S&P MidCap 400 and S&P SmallCap 600 in the five years before the enactment of Regulation Fair Disclosure (Reg FD). They also find that family firms are more likely to issue bad-news earnings warnings but overall make fewer forward-looking disclosures than non-family firms, and conclude that their results are consistent with family owners having a longer investment horizon and better monitoring of management, characteristics that obviate the need for greater disclosure.
This paper contributes to the growing literature on the disclosures of family firms by studying one of the most informative and common types of voluntary financial disclosures—the company’s own forecasts of its quarterly earnings per share—and sell-side analysts’ and investors’ responses to them. More specifically, we examine the characteristics of these disclosures (forecast specificity, surprise and accuracy), and the impact they have on important market indicators—professional analysts’ earnings estimates and stock prices. Thus, our analysis is designed to provide additional evidence on the relation between ownership structure and the quality of the firm’s information environment and, in particular, complements the existing empirical evidence on the characteristics and informativenesss of mandatory financial disclosures made by family and non-family firms (Ali et al. 2007 and Wang 2006).
As noted above, we focus on a particular type of voluntary disclosure, management’s forecasts of quarterly earnings per share, and do so for two reasons. First, prior research indicates that these forecasts are highly value-relevant—and more value-relevant than management forecasts of annual earnings per share (Pownall et al. 1993, Baginski and Hassell 1997). As a result, we believe that the quarterly forecasts are particularly well-suited for examining the different incentives family and non-family firms face in their attempts to control Type I and II agency problems, respectively. For example, higher quality forecasting by family firms (in terms of their forecasts being more specific, timely and accurate) is consistent with such firms creating a more transparent information environment and reducing a potentially severe Type II agency problem. Second, we are able to use a non-stock-price measure of the news in these management forecasts in our empirical work, which allows us to more effectively analyze the market’s perception of the differential information content in the forecasts made by family and non-family firms. We also separate our sample of forecasts into guidance (i.e., forecasts made prior to the end of the quarter) and preannouncements (i.e., forecasts made after the quarter ends but before earnings are released). We do this because the forecast horizon associated with preannouncements is very short, sometimes a matter of two or three weeks, and because much of the uncertainty regarding the forthcoming earnings number is resolved by the fiscal quarter end for most, if not all, firms, regardless of whether or not they are controlled by a family. Thus, the Type II agency problem in family firms, if it dominates the Type I agency problem, is more likely to be mitigated through the provision of guidance than preannouncements. This leads us to hypothesize that the characteristics of guidance, but not preannouncements, are systematically related to family-firm status, and that analysts and investors will react differently to the guidance, but not to preannouncements, issued by family firms, holding all else constant.
We test our hypotheses on the quarterly earnings forecasts made between 1998 and 2006 by the family and non-family firms in the S&P 500 index, as identified by Business Week (November 10, 2003) and contained in the First Call Company Issued Guidance (CIG) database. There are two aspects of our sample that should be highlighted. First, our sample firms are among the largest, most stable and most visible in the U.S. As a result, our results may not generalize to smaller, less visible family firms such as those included in Chen et al.’s (2007) sample. Second, our sample period spans the implementation of Reg FD. Thus, we provide evidence that complements the pre-Reg-FD evidence in Chen et al. (2007) and the limited post-Reg-FD evidence in Ali et al. (2007).
The results of our empirical tests generally indicate that the guidance provided by family firms is of higher quality than that provided by non-family firms. In particular, after controlling for other influencing factors, we find that the family firms in our sample provide significantly more specific guidance (in terms of forecast form and narrowness of forecast range) than non-family firms, especially when conveying bad news or offering confirmatory guidance. We also find that family firms use guidance to make smaller average adjustments to the market’s estimate of the upcoming quarterly earnings than non-family firms, especially when conveying bad news. This is consistent with their being more timely in offering corrections to analysts’ estimates. More importantly, we find some evidence of a stronger and quicker response by analysts (as measured by the number of subsequent earnings estimate revisions and the speed with which they occur) to the guidance issued by family firms, and strong evidence of a significantly greater investor response (as measured by announcement-period abnormal stock returns) to the guidance issued by family firms. These findings, taken together, indicate that guidance is more informative and more useful to the market when it is issued by a family firm. They are also consistent with family firms using guidance to create a more transparent information environment, which therefore, complements the finding of higher quality financial reporting by family firms in Ali et al (2007) and Wang (2006).
Consistent with our expectations, we find little evidence of differences in the characteristics of preannouncements issued by family and non-family firms, although there is some (weak) evidence of family-firm preannouncements being more specific when they contain bad news. Also consistent with our expectations, we find no evidence of a differential stock price response to preannouncements made by family and non-family firms, although we do find that analysts response more strongly to family-firm preannouncements, especially when they contain bad news. These results, when considered with the guidance results discussed above, suggest that family firms produce higher quality earnings forecasts than non-family firms, particularly when they are offered as guidance or contain bad news, and that their guidance is more informative and useful to investors and analysts. Thus, our paper provides evidence of family firms using management-generated earnings forecasts to create a more transparent information environment.
Our paper contributes to two bodies of research: the growing literature on disclosures by family firms, as noted before, and the established literature on management forecasts. While our paper is most closely related to Ali et al. (2007), Chen et al. (2007) and Wang (2006), who examine the mandatory financial disclosures of family firms and the frequency of their voluntary disclosures, we also complement Anderson et al.’s (2006) analysis of other dimensions of disclosure transparency. Anderson et al. (2006) find that family firms are significantly more opaque than non-family firms as measured by a summary statistic that captures the effects of trading volume, the bid-ask spread, analyst following and analyst forecast errors. Taken together, the evidence in Anderson et al. (2006) and our paper suggest that certain types of transparent disclosures appear to be better suited than others to mitigating the agency problem that arises between controlling and non-controlling owners.
The literature on management forecasts is more mature and, as a result, guides much of the structure for our analysis. Consequently, we follow prior work by Ajinkya and Gift (1984), Baginski and Hassell (1990, 1997), Bamber and Cheon (1998), Baginski et al. (2002, 2004), Ajinkya et al. (2005) and others, in designing our tests. In a recent paper, Hirst et al. (2007) provide a review of this literature and propose a framework for continued research in this area. They observe that choices concerning the characteristics of management earnings forecasts are not yet well understood and suggest that additional work addressing this issue is needed. Our contribution to the literature on management forecasts is to analyze the differential impact of Type I and Type II agency problems on the characteristics of management earnings forecasts provided by family and non-family firms, including the time of their release, as well as the market and analyst reactions to them. Thus, we add to the initial evidence on the underlying reasons for providing management forecasts in different forms and with different specificity—and on their impact of the stock prices of family and non-family firms. Finally, our results on confirmatory guidance support and extend the results in Clement et al. (2003).
The rest of the paper is organized as follows. In Section 2, we review of the relevant literature and develop hypotheses. In Section 3, we describe our sample and data, and in Section 4, we present the empirical tests. We offer concluding remarks in Section 5.
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