Theory and Hypothesis Development Association between Earnings Shocks and Stock Return

275 different from that to negative earnings shocks. Some studies find that the magnitude of stock price reaction to positive earnings shocks is larger in comparison to that to negative earnings shocks Lopez Rees, 2001; Ho Sequeira, 2007. Some other studies, however, find that the magnitude of stock price reaction to negative earnings shocks is larger compared to that to positive earnings shocks Skinner, 1994 and 1997; Soffer, Thiagarajan Walther, 2000; Conrad, Cornell Landsman, 2002. Regardless of inconsistent findings, investors are theoretically assumed to be conservative in that they will react more on good news than on bad news Basu, 1977. Positive earnings shocks, therefore, will lead to stronger reactions than negative earnings shocks will. Assuming that investors in emerging capital markets are conservative, we propose the following hypothesis. H 2 : In emerging capital markets inv estors‘ reaction to positive earnings shocks is stonger than that to negative earnings shocks. Association between Positive Earnings Shocks and Market Level Stock prices drift would be explained not only by earnings shocks but also by industry growth. Conrad, Cornel Landsman 2002, for instance, find that stock price increases positively relate to market levels. This finding suggests that the stock price increases decreases are driven by industry growth, i.e., the agregate stock price increases in specific industry that result from macroeconomic levels —market-up and market-down. Both market-up and market- down is indicated by an increase in firms‘ intrinsic value where the value is measured by priceintrinsic value PV. The firms‘s intrinsic value in this respect could not be determined by priceearnings ratio PE. The PV measure, therefore, is conceptually better than PE in determining the firms‘ intrinsic value for reasons that follow. First, it considers firms‘ growth prospects. Second, it considers firms‘ cost of capital. In conclusion, use of PV measure leads to Ohlson‘s clean surplus theory Frankel Lee, 1998; Lee, Myers Swaminathan, 1999. The PV measure, as contrast to the PE measure, is able to reduce the stock overprice. Based on the aforementioned arguments, the following hypothesis is developed. H 3 : In emerging capital markets, the earnings response coefficient of the positive earnings shocks increases along with the PV market levels. 276

3. Research Methods Data and Sample

Samples are drawn from companies listed in three emerging stock markets —Indonesia, Kuala Lumpur, and Manila Stock Exchanges —during the period of 2002-2007. Firms must meet the following criteria to included in the sample: i firms operate in manufacturing and financial sectors. Manufacturing sector includes consumptive goods industry, basic and chemical industry, service and investment trading, and others; ii firms publish audited financial statement for the period of 2003- β007; and iii firms‘ stocks are actively traded during the period. Data are taken from OSIRIS Database, Center for Social Study, Universitas Gadjah Mada and consist of daily return data, beta securities correction, and the dates of the earnings statement or financial statements published. Variables and Measurements Cumulative Abnormal Return Cumulative abnormal return CAR is the sum of the abnormal returns during the event period. The event period observed in this study is three days period after the dates of the earnings statement. Abnormal return is the difference between the actual return and the predicted return. AR

i,t

= R

i,t

– E[R

i,t

] Notes: AR

i,t

is the abnormal return of security number-i during the event period t, R i , t is the actual return for the security number-i during the period t, E[R

i,t

] is the expected return for security number-i during the event period t. The actual return is the return during the period of t which is the difference between current prices and previous price. Actual return is calculated using the following formula: R

i,t

= P

i,t

– P

i,t-1

P

i,t-1

Notes: R

i,t

is the return of security i during the period t, P

i,t

is the market price of the security i during the period t, P

i,t-1

is the market price of security i during the period t-1. The expected return is calculated using market model. The expected return calculation using market model is conducted within two stages, namely 1 emerging expected model using actual data during estimated periods and 2 using this expected 277 model to estimate the estimated return during the window periods. The expected model can be developed with the Ordinary Least Square OLS regression techniqES using following equation: j i Mj i i j i R R , , .       Notes: R i,j is the actual return of the security number-i during estimated period j, α i is the intercept for the security number-i, β i is the slope coefficient which is the beta coefficient of the security number-i, R Mj is the market index return during the estimated period j calculated using the formula of R Mj = CI j –CI j-1 CI j-1 , with CI is the Composite Index , Є i,j is the residual error of the security number-i during the estimated period j calculated using market adjusted model. The next step is the cumulative abnormal return CAR calculation using the following formula:    t t a a i t i AR CAR 3 , , Notes: CAR

i,t

is the cumulative abnormal return of the security number-i during the day number-t, which is the accumulated abnormal return AR of the security number-i after the event period of t +1 until t +3 , AR i,a is the abnormal return for the security number-i during the day number-a, which begins during t +1 days after event period until three days of event period t +3 . Earnings Shocks According to Ho Sequeira 2007, earnings shocks are calculated by subtracting forecasted EPS from actual EPS. Then the difference is divided by the closing price during the last day of the trading month before the date of the financial statement published. If the result is positive, the positive earnings shocks occur. Inversely, if the result is negative, then the negative unexpected return occurs.   1    t P FEPS AEPS ES Notes: ES is the earnings shocks, AEPS is the actual EPS, FEPS is the forecasted EPS.