The effect of profit warnings on stock returns of firms listed at Nairobi securities exchange

Abstract

Profit warnings are voluntary disclosures made by firms indicating that their expected earnings will be lower than 25% in comparison to the previous year’s earnings. Several reasons have been advanced as to why firms make such voluntary disclosures key among them being to avoid shareholder lawsuits and to minimize the overreaction that accompanies such warnings. The market reacts negatively to profit warnings because the market interprets such news as bad news. In this study, a sample of 13 firms that has issued profit warnings between 2010 and 2013 was analyzed using event study methodology where data was collected from Nairobi Securities Exchange for a period of 106 days (-90, +15). The event date was denoted as time zero (t=0) and a 31 day event window made up of 15 days prior to the event and 15 days after the profit warning announcement. Abnormal returns and Cumulative abnormal returns statistical significance was tested using the t-test. The study found out that stock returns are negatively affected by profit warning announcements as evidenced with a decline in abnormal returns around the event announcement period. The decline especially one day after the profit warning announcement and on the second day (t=-3.4494, P=0.0048) and (t=-2.9995, P=0.0111) was found to be statistically significant at 5% level. The study also established that there was a slight improvement in the stock returns from day +4 where the stocks resumed their earlier pattern although the market took long to recover from the effects of the profit warning because by day +15, the cumulative abnormal returns were still negative meaning that investors continued to make losses. Based on this study, we conclude that profit warnings negatively affect stock returns for those firms listed at NSE.