The current edition of The Economist takes the continuing debate over earnings guidance a couple of steps beyond the obvious.
The magazine (which we firmly believe should be required reading in every C-Suite in North America) cites the NIRI study we highlighted previously as evidence that quarterly earnings is becoming less prevalent than it was in the late 1990s. But the publication also looks into the reasons why, and the impact on companies and investors.
“Behind this trend is the belief that quarterly guidance, coupled with a fixation on whether companies match their forecast earnings per share (EPS) to the last penny, does more harm than good. Critics of the practice, who include not only company bosses but also regulators, academics and investors (among them, Warren Buffett), think companies are pushed into making poor decisions or tinkering with numbers to make sure that they hit their short-term targets.”
The article continues, “Research by K.R. Subramanyam and Mei Cheng, of the University of Southern California, and Yuan Zhang, of Columbia University, backs the critics up. The trio analysed the behaviour of nearly 1,000 companies, which they tagged as either “occasional” or “dedicated” guiders, between 2001 and 2003… The researchers found that dedicated guiders invested less in R&D and met or beat analysts' EPS estimates more often than occasional guiders did. In the long run, the earnings of dedicated guiders grew more slowly than those of companies that gave a steer less often (see chart above, courtesy www.economist.com).
“Proponents of earnings guidance also say that it benefits the capital markets by reducing uncertainty and therefore, in theory, companies' cost of capital. Some research analysts say that, at least in the short run, Wall Street forecasts for companies that stop giving guidance are all over the map, leading to more earnings 'surprises' and greater share-price volatility.
“Others fear that ending guidance can be a fig leaf for companies in trouble. In a recent study Shuping Chen, Dawn Matsumoto and Shiva Rajgopal, of the University of Washington, analysed 76 companies that have ended quarterly earnings guidance since 2000 (some stopped altogether, some moved to an annual basis). The researchers found that poor performers were more likely to reduce guidance.
“One welcome effect of the trend [toward less guidance] is that many of the companies that eschew quarterly earnings guidance are releasing, instead, more information on long-term trends and other financial measures. Mr Buffett's Berkshire Hathaway provides useful annual notes on the state of the company and on how its investments have done. IAC/InterActiveCorp, a media, retailing and online-business group, supplies information on its annual budget. Ultimately, it is data like these that help the markets—not the false precision of the next quarter's EPS.”
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