Tuesday, June 2, 2009

Stop the Earnings Guidance Madness

The subject of issuing earnings guidance is one for constant hand wringing by companies, analysts, commentators and even the National Investor Relations Institute.  Companies hate it, because their stock gets hammered if they miss their guidance by so much as a penny.  Analysts hate it because if they follow a company’s guidance and it turns out to be wrong, they feel duped.  On the other hand, if the analyst goes their own way and publishes an EPS forecast outside the company’s range, there is a good chance the company will either treat him as if he’s crazy, or nag him until he comes in line with the consensus. Reams of studies have been conducted about all of this, generally stating that the process puts too much focus on short-term quarterly results.

With all of this floating around, I thought that I would take a shot at bringing some light to the topic.  First, consider that analysts are not going to stop making estimates for quarterly earnings by companies just because companies stop giving earnings guidance.  Public companies in the United States report on a quarterly basis and, therefore, analysts will make earnings estimates on a quarterly basis, whether companies issue guidance or not. 

Further, whether or not a company issues earnings guidance has little to no effect on the pressure it feels to report good quarterly earnings.  To paraphrase one of my least favorite presidents, “It’s the earnings, stupid”. Companies that do not issue guidance feel pressure to hit the consensus earnings number that is every bit as intense as the pressure felt by companies to hit their guidance number. 

When the economy gets dicey, as it is now, issuing EPS forecasts becomes particularly hazardous.  When companies issue guidance, they almost never want to appear too downbeat, as it will act as an overhang on the company’s stock price for the foreseeable future.  So you usually get “cautiously optimistic” forecasts, which the company winds up revising downward as the year progresses.  Neither situation is good for the company.

So here’s my proposal – I call it “Less and More”.  Companies should give less in the way of specific EPS guidance; in fact, they should eliminate quarterly EPS guidance altogether.  In its place, I would suggest companies issue long term goals: revenue growth, key return criteria such as Return on Equity, Assets or Capital, the planned improvement in earnings growth and the manner in which they see achieving their goals, be it margin improvements, cost containment or simple growth.  These goals would be issued as target averages, with the explanation that any given year could vary from the goal, but over time, the expectation would be to achieve the target. 

On the other hand, companies should issue more short-term information in order to allow the market to work more efficiently.  This would involve companies releasing key performance metrics on a regular monthly basis.  This information would be along the lines of sales, order backlogs, customer mix, product mix and other key information that would allow investors to better assess the current state of business.  This would modestly increase a company’s reporting burden, but it’s not as if companies don’t already have this information – they run the businesses based upon it.  If they don’t have the information on at least a quarterly basis, they should.  Key metrics consistently reported monthly would increase transparency and help eliminate surprises.  By supplying what they consider to be important information on a monthly basis companies can eliminate the “black box” syndrome where investors have no idea what is happening at the company in between quarters.

It’s not a perfect solution for all concerned – some analysts will not be happy unless they have a direct feed from the reporting company’s mainframe computer, while many managements will groan at the thought of telling the street more.  What it will help to achieve is a better balance between allowing a company to focus on its longer-term goals, while supplying the market with timely short-term information that progress is being made towards those goals.

1 comment:

Jeffluth said...

I would propose a more radical approach (of course the SEC would need to get on board): let's eliminate quarterly reporting altogether and move to semi-annual or (shudder . . . annual) reporting of financial results. We can't move away from short-termism as long companies report on a quarterly basis. Eliminating guidance while providing more frequent operating metrics is a self-defeating exercise that only serves to increase volatility and sharpen the focus on near-term results. You can't have it both ways.