Differences of Opinion, Overpricing and Market Underreaction to Earnings Announcements

Prior studies find an insignificantly association between differences of opinion (DO) before earnings announcements (EAs) and the returns around the EAs and thereby reject the resale option theory that DO drives overpricing. We posit two issues that may lead to their conclusion to be one-sided. First, these studies used noisy DO proxies that are confounded by adverse selection. Second, DO and the resulting overpricing may not be largely reduced by the immediate EAs because of investors’ underreaction to the EA news. With a less noisy DO measure (DIFOPN), we verify the insignificant association between pre-EA DO and the EA returns. More importantly, we also find a significantly negative (positive) association between pre-EA DIFOPN and post-EA returns (contemporaneous returns), suggesting that pre-EA DO indeed results in overpricing, which gets corrected with a delay. We further confirm that stocks with higher pre-EA DO suffer greater underreaction to the immediate EAs