The Incremental Information Content of Tone and Sentiment in Management Discussion and Analysis

This study explores whether the Management Discussion and Analysis (MD&A) section of Form 10-Q and 10-K has incremental information content beyond financial measures such as earnings surprises, accruals and operating cash flows (OCF). It uses a well-established classification scheme of words into positive and negative categories to measure the tone and sentiment in a specific MD&A section as compared to those of the prior four filings. Our results indicate that short window market reactions around the SEC filing are significantly associated with the tone of the MD&A section, even after controlling for accruals, OCF and earnings surprises. We also show that the tone of the MD&A section adds significantly to portfolio drift returns in the window of two days after the SEC filing date through one day after the subsequent quarter’s preliminary earnings announcement, beyond financial information conveyed by accruals, OCF and earnings surprises. The Incremental Information Content of Tone and Sentiment in Management Discussion and Analysis There is a substantial body of literature in financial economics and accounting that examines the value relevance and information content of quantitative factors in the pricing of stocks. While economic and statistical modeling has become more sophisticated over the years, the somewhat disconcerting conclusion that seems to have emerged is that these quantitative factors inadequately explain movement of stock prices. Persuasive evidence of this is provided by Shiller (1981), Roll (1988), and Cutler et al. (1989), and others in the finance literature, who demonstrate that stock prices do not respond to change in quantitative measures of firm fundamentals as would be expected from models incorporating only quantitative variables of firm performance. In the accounting literature, Lev and Thiagarajan (1993), and Amir and Lev (1996), are two examples of research that have shown the inadequacy of conventional quantitative financial measures in pricing a firm’s stock. All in all, there is a growing realization that to develop a “good” stock pricing model, one has to incorporate not only the conventional quantitative measures of firm performance, but also include nonconventional measures such as potential market share (Amir and Lev, 1996), and even verbal, non-quantitative, difficult to quantify, kinds of measures. This is not totally surprising from a theoretical perspective. After all, stock prices are set by investors who, by definition, compute prices as the discounted present value of future cash payoffs conditional on the current information set available to them. It seems natural then to expect that the investor information set should include not only quantifiable information, but also non-quantifiable, verbal information, such as news