10-K Filing Size Impacts Volatility
The size of a 10-K report, an annual filing required from public companies by the Securities & Exchange Commission, is correlated with a stock’s price volatility. Stocks of companies with larger 10-K file sizes experience more price volatility in the period immediately following the filing date. These stocks also experience larger earnings surprises and have a greater dispersion of forecasts by the covering analysts.
These were the conclusions reached by two University of Notre Dame professors, Tim Loughran and Bill McDonald, in a forthcoming Journal of Finance paper. The two professors proposed replacing The Fog Index, a commonly used measure, with file size as a gauge for determining how readable a 10-K filing is. The professors believe the goal of readability should be “the effective communication of valuation-relevant information, whether it is directly interpreted by individual investors or assimilated and distributed by professional analysts.”
The Fog Index calculates a grade level score based on both the average number of words per sentence and the percent of complex words. Fog Index scores varied little among the nearly 66,707 10-K filings Loughran and McDonald looked at. More than 90% of the scores implied a post-graduate education was required to understand the text. This was primarily due to the common use of multi-syllable words such as management, corporation, customers and revenue. These words inflated the Fog Index score even though they are terms well understood by investors and analysts.
File size, however, is more relevant. The study’s authors’ opined, “If firms are trying to obscure mandated earnings-relevant information, it is unlikely that they will use sesquipedalian [multiple-syllable] words or complex rhetoric, and more likely that they will bury the results in longer documents. Additionally, litigation risk will incent managers to disgorge information whether it is useful or not.”
Loughran and McDonald found a “significant and nontrivial” relationship between an unusually large increase in file size and an increase in magnitude of earnings surprises. The dispersion of analyst forecasts also widened significantly when filing size increased by an unusual amount. Not surprisingly, price volatility is also higher, as would be expected if investors have difficulty determining key factors influencing a stock’s valuation from the 10-K filing.
Source: “Measuring Readability in Financial Disclosures,” Tim Loughran and Bill McDonald, Journal of Finance (forthcoming).