Matters of Guidance

In a recent discussion about public versus private companies, a couple of us were wondering about the exact pros and cons of earnings guidance (earnings forecasts or estimates) and what is the impact of not providing any quarterly guidance.

Why give guidance at all? Basically the market trades on expectations (expected earnings). The catch with not giving guidance is analysts drop coverage or make up their own forecasts. This could potentially shoo away institutional investors and create unnecessary volatility. The argument for company executives giving earnings guidance is that they are likely in a better position than analysts and hence they could predict more reliably what the quarterly earnings report is going to look like.

The argument against giving guidance is that it fosters market myopia, which in turn causes companies to adopt a short-term "earnings management approach", rather than take a longer-term strategic view, one that includes making rational capital investments.

In "To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance," the authors find no evidence that firms that stop giving guidance, offer better visibility on longer-term strategy including any additional capital investments. On the contrary, they point to issues with management and more earnings volatility (including losses).

Similarly, in "Is Silence Golden? An Empirical Analysis of Firms that Stop Giving Quarterly Earnings Guidance" the authors suggest that firms couch poor performance and low external demand for guidance in altruistic terms, when they decide to stop guidance. Furthermore, stopping guidance causes the market to reduce its expectation.

From an operating perspective, my own dilemma is how do you reliably forecast earnings? I can see the value in making an attempt, just so you get a feel for all drivers of earnings, but sharing it with the investors is just likely to force managers to do their best to meet their guidance. For instance, not dispose off sunk investments, play tricks with non-cash generating activities like depreciation etc.

Some interesting bits on this on the web....

Google, the darling of the Wall St condemns the practice of giving guidance:

Although we may discuss long term trends in our business, we do not plan to give earnings guidance in the traditional sense. We are not able to predict our business within a narrow range for each quarter. We recognize that our duty is to advance our shareholders' interests, and we believe that artificially creating short term target numbers serves our shareholders poorly. We would prefer not to be asked to make such predictions, and if asked we will respectfully decline. A management team distracted by a series of short term targets is as pointless as a dieter stepping on a scale every half hour.

NY Times article on The Rational Mr Buffet points out that:

Mr. Buffett is also against the practice of issuing quarterly earnings guidance, the self-imposed benchmarks that drive executives to sacrifice long-term strategy for a short-term payoff.

On the brighter side, there seems to be some rationality creeping up amongst investors. WSJ reports:

As the stragglers report actual results for 2006, investors have been unusually forgiving toward companies that have reported profits below expectations.

In an attempt to keep America's capital markets competitive, the chamber of commerce appears to have raised an issue with earnings guidance, among other things like Sarbox. Some of these are additional factors that may feed into the private equity, buyout binge.

WSJ reports:

The report, commissioned by the nation's biggest business lobby, called for an end to quarterly earnings forecasts, an overhaul of the Securities and Exchange Commission, and an increase in retirement savings.

The Economist appears to have a good article on this topic. I don't have access to it. If you are a premium subscriber you can access it here.