Wharton's Frank Zhou discusses his research on investor learning and firm disclosure.

In his latest research, “Disclosure Dynamics and Investor Learning,” Wharton accounting professor Frank Zhou examines the relationship between investor learning and earnings forecast decisions. He developed a structural model that illustrates the need for managers to understand where investor beliefs are when disclosing information. Zhou explained more to Knowledge at Wharton.

An edited transcript of the conversation follows.

Knowledge at Wharton: Could you give us a short summary of the paper and what question you were trying to answer?

Frank Zhou: I look at how investor learning affects firms’ voluntary disclosure decisions. By voluntary disclosure decision, I mean management annual earnings forecast decisions. We know that management annual earnings forecasts are very prevalent, so it’s an important question to ask: What are the forces that shape management earnings forecast decisions? Empirically, there is a very interesting phenomenon, which is that earnings forecast decisions tend to be “sticky” over time. I built a model trying to explain why the stickiness occurs and to empirically quantify this mechanism that I propose.

The mechanism is investor learning about unknown firm profitability. We know that investors don’t know everything, so it is a reasonable assumption that investors don’t know firm profitability. Just by taking this simple premise, I show that investor learning leads to sticky disclosure incentives.

“The effect of investors’ beliefs on firm disclosure choice depends on whether the beliefs are optimistic or pessimistic.”

The mechanism is really simple. Basically, investors have their prior information. Say that you invest in Apple; you think that Apple is a pretty good firm. Just observing that Apple’s performance drops a little bit at a certain time doesn’t mean that Apple is a bad firm for you. In other words, investors’ beliefs are sticky over time. I showed that investors’ beliefs, in turn, affect managers’ voluntary disclosure decisions. And that would lead internally to sticky disclosure incentives.

My structural estimation shows that investor learning leads to very sticky disclosure incentives so that there is a 10% increase in the likelihood of disclosure in one year caused by investor learning. That would, in turn, lead to about a 10% increase in the likelihood of disclosure in the next year.

Knowledge at Wharton: For investors, the more they learn, they more they confirm their beliefs about the firm?

Zhou: Yes.

Knowledge at Wharton: And the more they’ve confirmed their beliefs, the more the firm wants to disclose information about itself?

Zhou: The effect of investors’ beliefs on firm disclosure choice depends on whether the beliefs are optimistic or pessimistic. If the investors believe they’re optimistic, relative to actual firm profitability, that leaves less room for the manager to convey good news, and the disclosure probability would go down. This research shows that it is important for the manager to take into account where investors’ beliefs are when the manager decides whether to disclose the information.

Knowledge at Wharton: So, they would be strategic about disclosure versus where investors are with the firm at any given time?

Zhou: Exactly.

Knowledge at Wharton: If I’m a firm or an investor, how could I practically apply this research?

Zhou: This research is more from the manager’s perspective, to tell the manager to pay attention to where investors are. Often, we see empirically that some firms release some information that is not a big surprise, but there’s a very large market reaction, versus other times when management releases information that is a very large surprise, but there’s very little stock price movement. My research tells managers to pay attention to where investors’ beliefs are and how uncertain investors are about their beliefs when managers decide whether to disclose information.

Knowledge at Wharton: Are there key indicators in terms of where investors’ beliefs are at any given time? Is it just stock price?

“This research shows that it is important for the manager to take into account where investors’ beliefs are when the manager decides whether to disclose the information.”

Zhou: The key component would be the stock price, relative to what the manager believes where the firm’s fundamentals are. That’s the key indicator. The manager knows about the company, but the investor doesn’t know. They have some valuation about the firm, but the manager probably knows whether their firm is good or not. Based on that, that’s the key indicator of the investors’ beliefs.

Knowledge at Wharton: How are you going to follow up this research?

Zhou: I currently have a working paper on how investors process the information that is withheld from them. About 50% of the time, management does not issue earnings guidance. Typically, when this happens, it indicates bad news. And the investor kind of knows it’s bad news. But surprisingly, when the investor prices the firm, they actually overprice it. And when the earnings are announced, there is a subsequent decline in firm value. This is potentially important both to investors and to managers because, on the one hand, managers are supposed to inform investors about what’s going on. Or the manager could strategically take advantage of the investors’ inability to process the lack of disclosure. And from the investors’ perspective, they need to understand what the implications are of firms’ strategic decisions, in this case, disclosure choice. Firms make all kinds of strategic decisions, and it’s probably true that the investors have a hard time understanding them. So, this is the follow-up research.