Precise Earnings Forecasts May Be Smokescreens

Such precision is more likely a bid to manage impressions of a company in the wake of failings than evidence of insight by company leaders, researc...
David McCannMay 24, 2017
Precise Earnings Forecasts May Be Smokescreens

Research has consistently shown precise-sounding forecasts to have strong impacts, both in bolstering the self-image of those who make them and in impressing those to whom they are made.

Still, precision would seem hazardous for corporate Crystal ballexecutives when forecasts are as keenly scrutinized as those they make about their firms’ future earnings. A new study begins by asking a pointed question: “Why would top managers issue very precise judgment, particularly in the crucial domain of earnings forecasts or guidance of next year’s earnings, given that such precise judgment potentially induces errors and erodes their credibility?”

CFO Insights on Inflation, Workforce Challenges, and Future Plans 

CFO Insights on Inflation, Workforce Challenges, and Future Plans 

Download our 2022 survey report for a high-level view of finance team projections and strategies, directly from our executive readers.

The conclusion of the paper, published in the June issue of the Academy of Management Journal, is not encouraging to investors. Management forecasts that are relatively precise, the research found, generally do not derive from any special insight by the leaders who issue them. More likely, they represent an effort at managing impressions in the wake of company failures or stumbles.

And yet, such is the mystique of precision — or what is referred to in the study’s title as “pseudo-precision” — that the tactic evidently works.

Based on an analysis of earnings forecasts issued by a sample of almost 3,000 companies over a period of seven years (with about 90% of the forecasts in the form of predicted ranges), the study reports the following:

  • After missing the mark in earnings guidance the previous year, managers narrowed the range of their earnings-per-share prediction by an average of about three cents. That was a sharp increase in precision, given that the mean forecast spread for the sample as a whole was about eight cents.
  • After below-industry returns in the quarter prior to earnings guidance, managers tightened the forecast range by nearly two cents.
  • After a negative market reaction to a recent merger or acquisition, the forecast range narrowed by an average of about four cents, or half of the mean spread for the full sample.
  • Tendencies to be precise were strengthened in cases of “up-guidance,” when the level of earnings predicted exceeded levels previously forecast.

“On the surface, the presented results might seem surprising,” wrote the authors, Mathew Hayward of Australia’s Monash University and Markus Fitza of the Frankfurt School of Finance and Management in Germany. “When managers have experienced an organizational setback, they could be expected to exercise greater care in forecast accuracy. But results presented here are consistent with … evidence of managerial short-termism, wherein the motivation to be seen as being in control could trump that of being accurate.”

As for why this tendency becomes stronger in cases of up-guidance, the professors wrote that when managers “forecast a rosier picture after setbacks… [they] would be even more motivated to overcome skepticism by using more precise forecasts to strengthen impressions that they control firm strategy and performance.”

Transparent though these motives may seem, the study suggests that using precision as an impression-management tactic yields quite successful market results.

An increase from average precision to the maximum possible precision — where the forecast range is zero — will result in a market return that’s about half a percent (0.48%) greater than normal. Given that the average market capitalization in the sample was about $1.9 billion, such increased precision will increase a company’s market value on the announcement date by an average of about $9.18 million.

The professors analyzed data on earnings guidance, stock performance, and diverse operations of 2,918 companies over a seven-year period. Guidance was defined as the last annual earnings estimate issued by a firm in its fiscal year, provided it came at least one month before the fiscal year’s end. Measures of companies’ stock performance consisted of cumulative market-adjusted returns from the beginning of trading on the day before a guidance announcement to the end of trading on the day after.

In conclusion, the professors observed that “there is every reason to believe that precision would be used as an impression tactic well beyond this domain.” As an example, they cited research showing that during the global financial crisis of 2008, bank lenders sought to assure investors that their firms were solvent by making increasingly precise representations of their capital reserves.

Further, salespeople might use precision to gain authority with, and overcome the skepticism of, new customers. By contrast, they likely are less precise in representations to existing and more satisfied customers, where credibility is already established.

In the context of new products, companies might tend to make strong and precise representations about defect rates or performance because of their managers’ bias towards stronger impression management.

The same mechanisms are likely manifested outside the organizational context, such as when politicians forecast the costs of policies or actions and their likely outcomes.

“In each case, theory here suggests that the use of precision may have favorable effects on audiences and stakeholders,” the study’s authors wrote.

Understanding Which ERP Modules Your Business Needs – And When