Wednesday, May 30, 2012

Guidance? Here’s a Map - Find Your Own Way!

While there are sound reasons for some companies to issue earnings guidance, some of which I discussed last week, I want to go on record as stating that I don’t like companies giving guidance. Part of this is that I don’t like the gamesmanship that goes into the guidance number. (In business school, game theory was a continuous source of puzzlement to me – I never did figure out who was wearing the red hat.)
Because the market tends to penalize you heavily if you miss your guidance number, most companies sandbag the number to a certain degree. So after a few quarters where the company beats its guidance, analysts & investors have yet another reason to question the credibility of management. Then they start to raise their estimates because they are convinced that management’s estimates are too low, and management starts to get into the whole business of trying to keep analyst estimates in line. The end result is that it becomes a vicious cycle consuming a lot of investor relations time and effort that does little to help investors understand the intrinsic worth of the company.
So now that you know my bias, here are a number of reasons not to give guidance:
1.   Don’t give guidance if you are in an unpredictable business. This should be obvious, but you see it all the time. For example, insurance companies are in the business of underwriting uncertain risks. They don’t know when the next natural disaster will wreak havoc with their earnings, so it makes no sense for them to be giving guidance on earnings.
2.  Don’t give guidance if you are not very good at it. If your company has given guidance in the past, but you find that you have to constantly revise the numbers downward, guidance is more trouble than it’s worth. Find a better solution. (More about this later.)
3.  Don’t give guidance if it will cause management to engage is short-term practices that are not in the best long-term interests of the company. Jiggling things around to “hit the numbers” is a slippery slope at best and the road to perdition at worst.
Because the market is focused on future cash flows as a means of valuing your company, it will make an estimate of your revenues and earnings whether you help them or not. And if you don’t help them in some fashion, the dispersion of estimates will be wider than if they received some input from the company. But the input doesn’t have to be guidance.
If you feel that your company needs to give out guidance, then your company is not giving out enough interim information to let analysts and investors come to a reasoned estimate on their own. Many companies tend to be “black boxes” in between quarterly reporting periods.  This is unfortunate, because the ideal of a good corporate disclosure program should be to dispense enough information, and update the information frequently enough, so that investors are able to reasonably reach informed decisions about how you are performing.
For example, many retailers put out monthly sales numbers. By the time quarterly earnings come around, everyone knows the sales number for the quarter. For many companies, this eliminates guessing around one of the more uncertain numbers on the quarterly income statement and reduces the need for guidance.
Or consider Progressive Insurance, a company in an industry that is notoriously difficult to predict. Progressive doesn’t give out guidance. Instead, every month Progressive puts out a monthly income statement and balance sheet. And as a result, they are well followed and their stock trades with less volatility than many of its peers.
Alternatively, if your management really means it when they say they are running the company for the long-term, tell the market what your long-term goals are, and how you’ve performed against them. This is known as putting your money where your mouth is…


Jeffluth said...

Fully agree that not all companies should issue guidance. Dilemma is that for those companies with analyst coverage, the Street will publish estimates anyway. So the company is held hostage to Street expectations even if there is no official guidance. Might be better for all if analysts simply didn't publish estimates . . . and if companies reported on an annual basis, instead of quarterly.

pursuit said...

Interesting article! especially the part about how insurance company should not give out guidance, it is a volatile industry especially given the current instability in the macro environment.