Blog - Investing Notes

March 10, 2006 - Reading Between the Numbers

When a company reports earnings or makes presentations to analysts, should investors tune out the verbiage and focus only on the hard financial data? Or, do company executives give soft clues to future firm performance? In their January 2006 working paper entitled "Beyond the Numbers: An Analysis of Optimistic and Pessimistic Language in Earnings Press Releases", Angela Davis, Jeremy Piger and Lisa Sedor examine the "body language" of the narratives of earnings press releases and test the response of the stock market to this qualitative information. Using textual-analysis software to measure systematically the levels of optimism and pessimism in a sample of 24,000 earnings press releases published on PR Newswire between 1998 and 2003, they find that:

• Earnings press releases grow by about 15 words per month during 1998-2003.
• The ratio of optimistic words to pessimistic words in earnings press releases is nearly 3:1.
• Levels of optimistic and pessimistic language used by managers in earnings press releases reliably predict future firm performance.
• There is a significant market response to the levels of optimistic and pessimistic language in earnings press releases that is incremental to the current period earnings surprise and other factors.
• It does not matter whether the optimistic/pessimistic language comes from a direct quote from an executive or from other press release verbiage.
• The market has expectations regarding how much optimism and pessimism will appear in earnings press releases and reacts only to the unexpected portion.
• The market is likely calibrated to individual executives regarding use of optimistic and pessimistic language. It seems to ignore pumping and sandbagging.

In summary, executives of public companies use optimistic and pessimistic language to communicate credible information about expected future firm performance, and the market responds to this information.

But you have to "get to know" the executives to identify unusual levels of optimism or pessimism.

For related research, see Blog Synthesis: Sentimental Journey, encompassing a broad range of equity market sentiment measures. See also our blog entries of:

8/8/05 for an examination of the information content of earnings guidance;

7/26/05 on the potential influence of the Sarbanes-Oxley Act and associated enforcement focus to make executives conservative in the public outlooks; and,

5/31/05 regarding the predictability of the reactions of stock prices to specific types of company news.