Tuesday, May 22, 2012

Guidance – Part 1, Can’t Live With It, Can’t Live Without It

Back in the sexist days of yore, men had a saying: “Women – Can’t live with ‘em, can’t live without ‘em.” That’s sort of the way I feel about guidance, especially earnings guidance. Personally, I don’t like it, but I recognize there are times when it’s necessary. It seems to me that if you give guidance, and you hit your projected numbers, then you get no credit for it. On the other hand, if you miss the numbers you guided to, investors really penalizes you because they expect that you have better insight into the business than they do. And if you beat guidance, then you were sandbagging the numbers and analysts raise their future estimates so high that you are sure to miss in the near future.
Yet lots of companies give guidance, so they must feel they need to. According to a 2010 NIRI survey on guidance practices, of the 269 responding companies, 90% provide some form of guidance, 58% provide guidance on earnings/EPS and 62% on revenue or sales. Baruch Lev, in his book “Winning Investors Over” uses data from First Call and comes up with around 800 companies that provided quarterly guidance and 1,400 that provided annual guidance in 2007. Companies must feel compelled to issue guidance because no sane businessman is going to want to make a public forecast unless he is forced to do so.
So I went looking for some data to see if guidance was a good thing or not. Not surprisingly, the data is mixed. In his book Baruch Lev cites a number of academic studies in support of giving guidance. First, there is a study that shows that companies are more accurate at quarterly guidance than analysts. (This, of course, is not evidence that company guidance is necessarily very accurate, just that it’s more accurate than analysts’.) Second, he cites studies that indicate that guidance enriches the information environment in the capital markets. By this I think he means that the very act of giving guidance is another piece of information, which helps improve transparency. And academic studies show that transparency leads to higher stock prices, lower stock volatility and reduced cost of capital.
On the other hand, the consulting firm McKinsey, in a study published in the Spring of 2006, concludes “Our analysis of the perceived benefits of issuing frequent earnings guidance found no evidence that it affects valuation multiples, improves shareholder returns, or reduces share price volatility. The only significant effect we observed is an increase in trading volumes when companies start issuing guidance…”
So there you have it: dueling experts that lead you to exactly opposite conclusions. Given that it is not totally clear that guidance is for every company, I thought I would try to lay out some of the thinking that might lead a company to make an informed decision regarding guidance. My next post will take the opposite side, citing the reasons not to issue guidance and discuss some of the alternatives that I think are better.
You should engage in guidance if:
1. You are a small cap company and have low sell side analyst coverage. One of the big issues for small cap stocks is getting on the radar screen of analysts and getting coverage. Anything a company can do to improve their chance of coverage, including issuing guidance, should come into play in order to gain the increased trading volumes, liquidity and visibility that come with increased sell side coverage.
2.  You are in a predictable business with good insight into near term revenues and profits. Companies with recurring revenue streams or large backlogs of orders to be fulfilled in the near future are an example here. Businesses with wide swings in revenues dependent upon one-time orders are not good candidates.
3.  You don’t want to give continuous updates on your business in between quarters. The more transparent you can be on a continuing basis, the less you need to help the street by giving guidance. (More on this next week.)
4.  Management has the intestinal fortitude to run the business to plan and not manage the earning to hit guidance. Accounting is full of subjective judgments and timing issues. It is possible to move revenues into the current quarter or fiddle with loss reserves to make earnings look better in the quarter so you hit your guidance. This is almost never a good thing, but the pressure to “hit the numbers” can be overwhelming at times. Don’t issue guidance if it is going to warp the way you run your business.
5.  You figure that the market is going to make a forecast anyway, so why not take control of the process.
I suspect there are many companies that give guidance that do not fit any of the above reasons, but instead do it because all of their peer companies give guidance. This is probably the worst reason to do it, and for support, I cite motherly wisdom about all your friends jumping off a cliff.

1 comment:

Jeffluth said...

I think the bigger issue is the question of earnings warnings; a custom, the Bard would say, more honored in the breach. Especially when a company blows through "guidance" and reports a material upside. Where is the liability? Where is the "duty to update" that NIRI used to flaunt? What is the point of issuing guidance if there is no accountability?