On Corporate Earnings Forecasts

From the March 13, 2006 Financial Times:  ”Opposition grows to earnings forecasts”.  With Pfizer joining a growing group of heavyweight companies opting to eschew the practice of providing earnings guidance, a consensus is forming among chief executives, analysts and regulators against the practice.

In my role as a member of the disclosure committee and a corporate accounting controls executive at my Fortune 100 corporation, I am keenly interested in the arguments for and against the ritual of providing earnings guidance.  The classic arguments go that earnings guidance reduce volatility and increase share valuations.  However, McKinsey is the latest to conclude that these notions are not supported by empirical data. 

In fact, the opposite may well be true as hedge funds prey upon the hyper-short-term opportunities created by earnings guidance.  Even long-only funds have been forced to shorten their investment horizons in the current market environment, putting even their interests at odds with those of management.

In addition, one might argue that the practice of issuing guidance by management reduces the objective analysis that was intended to be performed by the analyst community.  Spoon-feeding future expectations results in an analyst community that is unwilling, and potentially unable, to complete substantive research and coverage of a stock.   As a result, serious investment recommendations are being issued by analysts who do not understand the products, the market or the strategy of the company they are covering. 

So the question is, what should replace earnings guidance?  Some have proffered a system of “earnings dashboard” measures, which investors could use themselves to make determinations about future growth and earnings potential.  Others have promoted a much more regulatory heavy-handed approach akin to the current system of GAAP reporting. 

It is my opinion that expanded or augmenting the already rigid system of GAAP reporting to include earnings-centric metrics will overload an already burdensome system of compliance.  Further, it will reduce the very value of information it is intended to create, instead becoming focused on legal and regulatory compliance.  Instead, I believe a dashboard system and a return of responsibility for analysis to the investor would be much more healthy for corporations, shareholders, and the market.

--By Pamela Strayer

Comments

[randolfe]

My comment is that I find it odd and a bit depressing that, despite the fact that finance professors at esteemed business schools have been saying (and proving) all along that earnings guidance does nothing to help volatility or share price, now that McKinsey regurgitates their work it is newsworthy. I hadn't thought about the impact that hedge fund activities might have on actually increasing volatility because of guidance though. That alone may make McKinsey's work worth something.

[Peter P]

Randy, which software did you use to generate the stock chart image?

[randolfe]

It's a custom application built with ILOG's JViews component suite.

[TN]

Off Topic:

On an old thread on patrick.net, you mentioned that Bernanke was not the first choice for Fed chair and that the first choice turned down the position for some reason. I was wondering if you can give supply some links about the subject. Thanks.

[tjrsfca]

The thrust of this article misses the forest for the trees. Guidance is incredibly helpful to the analyst community, but it is not as significant as the investing community has deemed it.

When putting together a forecast for the next four quarters, an analyst has to make many assumptions based on historicals, comps, their own channel checks, and intuition. There are so many levers to pull or dials to turn that any analyst's forecast is a castle in the sky. Frankly, the forecasts of the companies themselves aren't significantly better which brings the first point, guidance is just that: guidance. It isn't a guarantee of anything, but it is an indicator of what the company is thinking which creates a signpost for the analyst community to orient themselves. Analysts are free to disagree based on their own research, but as Pamela points out, most of them find it expeditious to simply take what's spoon-fed them. But simply by paying attention to who is correct more frequently should be a good sign as to who is doing actual research.

I think it is reasonable for companies to give out the guidance for the next quarter. If they wish to make the range broad, fine. Whatever you do, do it consistently and predictably and the analysts will get their value. And this almost goes without saying, but not all analysts know a stock better than you do... but some do. Pay attention and you'll see who is stronger on what names. I wonder if you controlled for that if the McKinsey report would show a decrease in volatility.

[randolfe]

Off Topic Reply to Fed Governor Question:

A link can be found at http://www.slate.com/id/2127984/

I had heard that Hubbard was tapped first because of his deep political connections to the current administration, but he turned it down for family reasons. I also heard that at least 1-2 others also turned down the opportunity, when approached.

Another excerpt I found regarding who was in the running: Economists and market analysts have focused on a short list of possible choices, including Harvard professor Martin Feldstein, White House Council of Economic Advisers Chairman Ben Bernanke, Columbia University professor R. Glenn Hubbard, Fed Governor Donald Kohn and Fed Vice Chairman Roger Ferguson.

[randolfe]

I wonder if you controlled for that if the McKinsey report would show a decrease in volatility.

My response to this is that it is often possible to reduce volatility by segmenting the sample data. I would propose that, assuming that some analysts are better than others:

a) so long as at least a significant portion of the investment community is either willing to listen to sub-standard analysts or unable to distinguish between top analysts and sub-standard analysts;

b) the market for stock equities is price efficient;

c) hedge funds find opportunity in the divergence between corporate earnings guidance implications and analysts predictions, even if driven or significantly impacted by the community of sub-standard analysts;

Therefore, there will be observable increases in volatility caused by the practice of corporate earnings guidance.