Assessing technical efficiency: effects on future profits and returns

Theory suggests that relatively inefficient firms should have lower and more uncertain future cash flows than their efficient peers, which should lead to lower current equity values and higher future returns. However, we find that inefficient firms experience significantly lower returns than their more efficient counterparts. We provide evidence that a possible reason for the negative drift in returns is that investors are not fully aware of firms’ operational inefficiencies and are negatively surprised when future negative earnings are announced. Furthermore, we document that analysts do not properly incorporate information about operational inefficiency into their earnings forecasts and target prices and seem to overlook the issue of operational efficiency during conference calls, particularly for inefficient firms.