Earnings Announcements, Aggregate Earnings, and Individual-Firm Stock Returns: A Signal Extraction Perspective

There is an extensive stream of research that documents a positive association between earnings surprises and stock returns at the individual firm level. We posit that individual firms’ earnings surprises have systematic and firm-specific components that differ in their persistence, implying that the market reaction to individual firms’ earnings surprises should depend upon the relative magnitudes of the underlying systematic and firm-specific earnings surprise components. We further posit that investors behave as if they solve a signal extraction problem that allows them to estimate from aggregate (e.g., market) earnings the systematic earnings surprise component. Our signal extraction framework implies that the market reaction to individual firms’ earnings surprises is increasing in the cross-sectional mean earnings surprise and that the magnitude of the mean effect is inversely related to the cross-sectional dispersion of the earnings surprises. Our results are consistent with these predictions. Also consistent with signal extraction, we find that the effect of the crosssectional mean earnings surprise is significantly larger for firms that announce their earnings early in the quarter. We also find that signal extraction occurs for firms with a large percentage of individual investors, but not a large percentage of institutional investors, consistent with institutional investors having private information that allows them to partition a firm’s earnings surprise into its systematic and firm-specific components. Overall, our results suggest that to understand the market reaction to individual firms’ earnings announcements, one must consider aggregate earnings.