An analytical measure of market underreaction to earnings news

Abstract Prior studies have provided a number of possible explanations for delayed market reactions to earnings announcements. However, there has been relatively little effort to predict the magnitude of the post-earnings announcement drift (PEAD). We show that the squared correlation coefficient ( ρ 2 ) between order imbalance and earnings surprise determines the magnitude of market underreaction to earnings surprises and P E A D = k ⋅ ρ 2 , where k is the information content of earnings. We discuss several testable implications of our analytical results, including a model-implied measure of information asymmetry that arises from the differential information processing ability of traders.