Is it Time to Reconsider Earnings Guidance?

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Explore:  Annual Reports

I always enjoy Warren Buffet’s annual letter to Berkshire Hathaway’s shareholders. While it’s true that he, like most (all?) heads of public companies, can’t resist a healthy dose of bragging about recent successes and their bright future, he always mixes in enough self-deprecation, humor and business insights to make it an interesting read. This year’s letter was no exception.

A tidbit that caught my eye this year was the fourth of his six “fundamentals of investing.” Having related a story about making a small investment 30 years ago that steadily became large over the decades, Buffet makes the following observation:

“Games are won by players who focus on the playing field—not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.”

Admittedly, he was not speaking directly to the wisdom (or lack thereof) of companies providing earnings guidance. However, I couldn’t help thinking that the same principles apply.

Despite a steady decline over the years in the number of companies providing earnings guidance (particularly quarterly), most companies continue the practice. The reasoning seems to be twofold:

  • Earnings guidance indicates management’s performance expectations and helps investors understand the company’s business. It provides transparency. What could be wrong with that?
  • “Our investors and analysts insist on guidance. Our peers give it, as well. If we stop, our stock will get hammered.”

Studies show, however, that there is little to no correlation between providing earnings guidance and superior stock valuation. Likewise, discontinuing guidance appears to have no long-term effect on the stock price or trading volume. (See this McKinsey & Company study.) In other words, even if your stock is impacted in the short run (which is not a given), in the long run there should be no adverse effect.

The bigger danger, it seems to me, is senior management’s ongoing struggle to establish, communicate, caveat, manage to and ultimately meet earnings guidance, as well as the market expectations it creates. Here are some common guidance-driven problems:

  • Management often frets over “missing earnings.” Despite good faith efforts to prioritize long-term decision-making, some executives find it difficult to avoid frequently checking the company’s stock price and letting its direction dictate their moods.This can blur the lines between decisions made to avoid market reaction to an earnings miss versus those that create long-term value.
  • The current emphasis on performance-based compensation can compound the problem if a significant percentage of management’s compensation is tied to market-driven criteria and there are insufficient countervailing compensation incentives.
  • Senior management’s direct reports may be tempted to spin information and take risks to facilitate what they perceive to be their superior’s earnings expectations, rather than to reflect the current reality.
  • Deciding whether, when and how to update previous guidance can be a difficult, contentious internal debate when things don’t go as planned, as they are wont to do.
  • The time spent dealing with analysts and key stockholders each time there is a blip in the stock price or short-term performance, not to mention preparing for and attending analyst conferences, can be far better spent managing the business itself.
  • Missing guidance can subject a company, its management and its directors to stockholder litigation liability and loss of credibility.

Most companies’ earnings simply cannot be easily predicted from period to period, and that reality doesn’t change just because the analysts desperately wish it were so. A good analyst is supposed to understand such concepts as short-term disruptions, seasonality and economic uncertainty. They’ll do just fine without specific earnings guidance.

Even so, it is always good practice to be as transparent as is reasonably possible regarding current operations and prospects. This can be better accomplished, however, through more helpful disclosure of strategies, risks, industry trends and the like, rather than by providing an earnings range.

If you currently provide quarterly earnings guidance, consider shifting to annually. If you provide annual guidance, consider going guidance-free. You’ll very likely be glad you did.

Topics:  Annual Reports

Published In: General Business Updates, Securities Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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