# How to model the effect of earnings surprises on long-term returns?

I'm looking into modeling the relationship between EPS announcement surprises with long-term returns (1 quarter to 3 years with intervals). I've based my current methodology off papers looking at the short term effect (example) but I think that the long time horizon will require a more comprehensive solution.

My ultimate goal is to be able to say with some degree of certainty whether or not beating or missing analysts' EPS estimates has a long term effect on the performance of a stock.

I've set up a regression with variables as follows:

I've defined EPS announcement surprises as

$$\text{SUPRISE}_i=\dfrac{\text{EPS}_{actual,i}-\text{EPS}_{estimate,i}}{\text{EPS}_{actual,i}}$$

to create 2 variables for positive and negative surprises (POSSUPRISE and NEGSUPRISE)

Defined Returns as

$$\text{RETURN}_t=\ln(\text{price}_{i+t})-\ln(\text{price}_i)$$

where $t$ is the final day of the time period I am analyzing

so my current regression looks like this

$$\text{RETURN}_t = \beta_0 + \beta_p \text{POSSUPRISE}_{i}+\beta_n \text{NEGSUPRISE}_{i}+\epsilon_t$$

I've also done a regression with indicator variables for beating and missing estimates

I've run this over a sample set of 30 large cap stocks with EPS data from 1999-2009 and the appropriate pricing data and so far have had mixed results, I found some correlation between 2 year returns and large earnings surprises, but before I explore this question further, I want to make sure I'm going about it the right way

My questions are:

1. Is a regression of individual instances the best way to analyze this problem? Should I use time series methods like VAR instead?
2. What is the best way to incorporate broad market movement into the returns data? Should I just adjust the return variable to account for the return on an index over the time period as well or is there a better solution?
3. Am I better off just considering the surprise variable or should I try to control for other variables in the model such as actual EPS, Market Cap, etc?
• Hi EHC, welcome to QuantSE. I'm afraid your question is actually extremely vague: what are your inputs? what do you call a surprise? and frankly your questions are just as vague. You should try to first have a simple prototype with a couple of results and then try to refine by posting what you've done. – SRKX Oct 29 '14 at 2:19
• Good edit. Good attitude. I reopened it. – SRKX Oct 29 '14 at 3:26