Providing Earnings Guidance? Think Again
1:00 PM Friday May 4, 2012 by Bruce Nolop
As we saw again this quarter, earnings announcements can have significant impacts on stock valuations—at least over the short term. Investors reward companies (such as Apple and Kimberly-Clark) whose current performance or guidance for the future exceeds market expectations, and they punish companies (as they did Starbucks and Procter & Gamble) whose performance or guidance fails to meet expectations.
As we conclude another earnings season, then, it’s a good time to consider the advisability of providing earnings guidance. It’s a question that has defied consensus, with valid arguments on both sides of the issue.
First, let’s review the case for guidance. The arguments center on the value of establishing increased transparency with investors, and include:
Higher Stock Price: The advocates for guidance argue that it can result in a higher stock price. Although the empirical evidence is mixed, this argument has intuitive logic: Because investors abhor uncertainty, knowing management’s expectations is a valuable data point that can strengthen their confidence in the investment.
Decline in Stock Analysts: Guidance provides particular value, argue some, given the decline in coverage by sell side brokerage analysts. By helping to fill this analytical void, CFOs can make it more likely that the market will develop expectations that are grounded in reality.
Flexibility in Communications: Providing guidance also gives CFOs more leeway to discuss their company’s outlook between earnings announcements. Otherwise, they may be shackled by Fair Disclosure (Reg. FD) constraints.
Less Volatility in Stock Price: The net effect of providing guidance is arguably a less volatile stock price, which can result in a lower beta and a lower cost of capital.
Countering these are the points that make up the case against guidance, Here, the arguments center on the riskiness of the practice in light of uncertain economic and financial environments.
Inherent Unpredictability: The principal argument against guidance is that it flies in the face of uncertainty, with many of the key variables outside the company’s control. As highlighted by the financial crisis, the world is rife with unpredictable forces that can affect revenue streams, costs of goods and services, and mark-to-market accounting judgments.
Margin of Error: The unpredictability of the environment is compounded by investors’ fixation on a relatively narrow band of expected results—often within a statistical margin of error. When investors overreact to a “miss” of one or two cents in earnings per share, the guidance can introduce more, rather than less, volatility in a company’s stock price.
Increased Disclosure Obligations: If it becomes apparent that a company is likely either to exceed or miss its guidance, the question arises as to whether it should pre-announce its earnings. In contrast, if it has not provided guidance, the company is under less legal and market pressure to make a special disclosure in advance of the scheduled earnings announcement.
Whisper Numbers: Investors may become skeptical if the company has a propensity to provide lowball estimates that it almost always exceeds. This in turn can produce whisper numbers in the market, making it confusing to discern whether the company has in fact met or exceeded the market’s expectations and perhaps eroding the CFO’s credibility with the investment community.
Potential for Bias in Accounting: Because accounting judgments involve some subjectivity, providing earnings guidance can introduce the potential for bias—either consciously or unconsciously—in the preparation of a company’s financial statements. This potential is compounded if relatively small amounts can make a material difference in investor perceptions.
After weighing the pros and cons, I come down on the side of not providing guidance. I have reached this conclusion after an evolution in my thinking, which was profoundly influenced by my experience as a CFO during the recent recession and financial crisis.
However, I also believe in increased disclosure concerning the earnings drivers. By providing additional information about the variables that affect performance, CFOs can assist both sell side and buy side analysts in deriving their forecasts and can reinforce a reputation for transparency in investor communications.
For example, CFOs can regularly highlight their company’s sensitivities to exogenous factors (such as foreign exchange and interest rates); company-specific factors that affect revenue (such as price levels and demand elasticities for products or services); programs to lower the cost base (such as forecasted trends in major cost categories); the potential impact from major accounting assumptions (such as the pension fund discount rate or the depreciation and amortization schedules for major assets); or unusual factors that will affect the upcoming quarter or year (such as an expected gain or loss on an asset sale or a potential exposure due to a legal settlement).
In addition, they can provide guidance concerning parts of the income statement that are especially unpredictable. For example, tax calculations are notoriously volatile; for clarity, the CFO can regularly update investors concerning the expected effective tax rate for the quarter and year.
CFOs can be similarly transparent concerning the key performance metrics that will drive future revenue and earnings. For example, they can update investors concerning the number of customers, the headcount trends, or the anticipated spending on marketing and advertising. Investors will appreciate knowing the metrics that the CFO thinks are important, as well as the company’s current performance against those metrics.
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