Analyst Report Readability and Stock Returns

• Author: Yao Zhang,Kai Wai Hui,Chia‐Chun Hsieh
• DOI: http://doi.org/10.1111/jbfa.12166
• Date: 01 January 2016
• Published date: 01 January 2016

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 43(1) & (2), 98–130, January/February 2016, 0306-686X

doi: 10.1111/jbfa.12166

Analyst Report Readability and Stock

Returns

CHIA-CHUN HSIEH,KAI WAI HUI AND YAO ZHANG∗

Abstract: This study investigates the market’s response to analyst report readability. We

posit that readable reports decrease uncertainty of earnings expectations and by extension

increase stock prices. Our results show that the equity market reacts more positively to readable

reports and that this positive reaction is attributable to a reduction in uncertainty of future

performance. Moreover, we find that the effect of readability on stock prices is significantly

positive only for firms with greater R&D spending, higher bid-ask spreads, a greater proportion

of uninformed investors, and more experienced analysts, which suggests that readability matters

only when information asymmetry in the equity market is high.

Keywords: readability, analyst reports, stock returns

1. INTRODUCTION

Analyst forecast reports can provide investors with valuable insight into a firm’s

future profitability. For example, Asquith et al. (2005) suggest that analyst discussions

of the research logic and justifications behind their forecasts can help investors

better understand firm value. Readability is a linguistic feature that improves the

effectiveness of written communications. In one study, Lehavy et al. (2011) provide

empirical evidence that less readable 10-K filings are associated with greater overall

uncertainty in analyst earnings forecasts. Similarly, De Franco et al. (2014) suggest that

greater readability allows investors to obtain more precise information from a report.

Although analyst reports contain value-relevant information and are associated with

significant market reactions (Frankel et al., 2006), it is unclear whether investors price

the readability of analyst reports favorably. To answer this question, we examine the

market’s reaction to the readability of analyst reports.

∗The first author is at the Department of Accounting and Information Technology, National Chung Cheng

University, Chiayi, Taiwan. The second author is at the Department of Accounting, Hong Kong University of

Science and Technology, Clear Water Bay,Hong Kong. The third author is at the Department of Accounting,

Tongji University, Shanghai, China. The authors thank Philip Berger, John Core, Patricia Dechow and

Mark Defond for their insightful comments. The authors also benefited from comments from Kin Lo,

Joy Begley, Sandra Chamberlain, Gilles Hilary, and workshop participants at the University of British

Columbia, INSEAD, National Cheng Kung University, Xiaman University, the 2011 and 2013 American

Accounting Association Annual Conference and the 2011 Canadian Academic Accounting Association

Annual Conference. Hsieh and Hui acknowledge financial support from the Hong Kong Research Grants

Council (project No. 641310). Any errors are those of the authors.

Address for correspondence: Yao Zhang, Department of Accounting, TongjiUniversity, Shanghai, China.

e-mail: zhangyao@tongji.edu.cn

C

2015 John Wiley & Sons Ltd 98

ANALYST REPORT READABILITY AND STOCK RETURNS 99

We argue that the stock market reacts positively to analyst reports with better read-

ability. Our hypothesis is based on the idea that a readable report decreases uncertainty

of future earnings, as readers find a well-written report easier to understand (Lehavy

et al., 2011). This lower uncertainty decreases the information-processing costs of

investors and allows them to apply analyst forecast revisions to their trading decisions

with greater certainty, which decreases the estimation risk and discount rate when

valuing a firm (Bloomfield, 2002; Lehavy et al., 2011). Moreover, the reduction in

uncertainty about a firm’s future earnings also helps to decrease the information

asymmetry between uninformed and informed investors, which decreases the discount

rate. Therefore, from the perspective of firm valuation, higher readability lowers

uncertainty and the discount rate, which results in higher stock prices. In addition

to its effect on the discount rate, whether readability affects firm valuation through

changes in earnings expectations is an open question. This is because readability may

be either orthogonal to or positively associated with earnings news in analyst reports

(e.g., Li, 2008). Combining the possible effects of readability on the discount rate and

earnings expectations, we expect a positive relationship between readability and stock

price reactions.

This study focuses on analyst reports on firms in the high-tech industries. This allows

us to obtain a sample of firms with consistent industry backgrounds and a strong need

for analyst research (e.g., Barth et al., 2002; Barron et al., 2002). We follow Li (2008)

and others and apply the Fog index to measure report readability.1Using an event

study design, we examine the influence of report readability on firm value by analyzing

stock returns at the time analyst reports are issued. This short event window helps

mitigate endogeneity concerns related to a potential correlated omitted variable. In

addition to studying the association between readability and stock prices, we explore

whether this association is due to a reduction in uncertainty about a firm’s future

earnings. Finally, we examine the conditions in which readability may have a stronger

effect on stock prices.

The results of our study show that stock returns at the time of analyst report issuance

are significantly more positive for firms with readable analyst reports. We find that an

increase of one standard deviation in readability increases a 3-day abnormal return by

about 0.58%. We also find that uncertainty of future performance, which is measured

by implied volatility, is inversely related to report readability. We also investigate

whether our results are caused by increased expectations of future earnings. However,

we find no evidence supporting an association between readability and changes

in earnings expectations. In summary, our results suggest that the market reacts

positively to more-readable reports, as such reports decrease investors’ uncertainty

about earnings expectations.

We provide further insights into our main findings by conducting cross-sectional

tests involving scenarios in which report readability is more likely to influence stock

prices. We expect that readable reports have a greater role in decreasing uncertainty

in situations where firms are difficult to value, have high information asymmetry, have

less-sophisticated investors, or are covered by more influential analysts. We conduct

empirical tests of these predictions using four measures: 1) research and development

(R&D) expenses (Aboody and Lev, 2000), 2) the bid-ask spread (Brennan and

Subrahmanyam, 1996), 3) investor sophistication (Mikhail et al., 2007), and 4) the

1 Our results are robust to the use of either the Flesch or Flesch-Kincaid measures of readability.

C

2015 John Wiley & Sons Ltd

100 HSIEH, HUI AND ZHANG

level of analyst experience (Mikhail et al., 1997). Our findings show that the market

reacts positively to readable reports only when firms spend more on R&D, the bid-ask

spread is larger, investors are less sophisticated, and the analyst issuing the report is

more experienced. These findings support our conclusion that more-readable reports

reduce investor uncertainty, which translates into higher stock returns. In summary,

our findings suggest an important insight that readability matters only when the

market has high information asymmetry.

We conduct several additional analyses to ensure the robustness of our findings.

First, to ensure that our findings are not driven by potential information omitted from

analyst reports, we re-run our tests by including more information-related variables.

Moreover, we match the sample reports in pairs by firm with the closest level of analyst

forecast revisions. In both tests, readability is positively related to stock returns. Second,

to examine whether earnings announcements play a role in our findings, we add

control variables for concurrent earnings announcements. Our results remain robust

to the inclusion of these control variables.

This study makes several important contributions to the literature. First, it con-

tributes to the accounting and finance literature related to report readability. Studies

have found that readability provides value-relevant information. For example, Lehavy

et al. (2011) find that less-readable 10-Ks are associated with lower analyst forecast

accuracy and greater dispersion. In another study, De Franco et al. (2014) find that

analysts with greater ability are more likely to issue more-readable reports. These

reports represent more precise information and are consequently associated with

larger trading volumes. However, although studies have examined the effect of report

readability on analyst forecast dispersion and trading volume, they have not examined

whether investors price the readability of analyst reports using signed returns. Thus,

our finding that the market reacts positively to analyst report readability extends the

literature by suggesting the value premium of readability.

Second, our study contributes to the literature related to analyst reports, which

shows that these reports are important outputs from financial analysts and are widely

read by different types of investors (Hirst et al., 1995; Frankel et al., 2006; Mikhail

et al., 2007; Kadous et al., 2009). In particular, Asquith et al. (2005) provide empirical

evidence that analyst reports are value relevant, as they help investors understand

the value of a firm.2Readability reflects the writing and is an inseparable part of

analyst reports. Therefore, by providing empirical evidence of the market reaction

associated with readability through decreasing earnings uncertainty, our findings

extend the literature related to whether and how analyst reports provide value relevant

information to investors.

Although we conduct a series of robustness tests, our findings should be interpreted

with caution. First, we may not fully control for the forecast news in the tests. Our

main findings are robust after matching reports with the closest forecast revision

and controlling the additional proxy for report information (i.e., target price and

recommendation revisions). However, to the extent that readability may be correlated

with any news in the analyst report, it adds noise to our tests. Second, our tests

focus on a sample of high-tech firms for which analyst research is most valuable.

2 De Franco and Hope (2011) find that the trading volume and unsigned market reaction are associated

with the issuance of analyst notes, a form of analyst disclosure used to communicate day-to-day timely

information.

C

2015 John Wiley & Sons Ltd