Capital Markets

Getting Out of the Game

Will ditching earnings guidance lead to share price volatility? Also: the hole in Black-Scholes.
Tim Reason and Joseph McCaffertyMarch 1, 2003

In late January, McDonald’s Corp. announced it lost $344 million in the fourth quarter — its first quarterly loss ever and more than four times greater than it had forecast just five weeks earlier. The world’s largest restaurant owner then said it was bagging future earnings guidance, at least for 2003.

“We have learned over the last year that we are not very good at making predictions, so we decided to get out of the predicting business,” lamented CFO Matthew Paull during the company’s quarterly conference call. “We are going to focus our entire organization on the long term and try to take the focus off the short term.”

The decision comes on the heels of a similar conclusion by The Coca-Cola Co. and AT&T Corp. to forgo quarterly earnings guidance in an attempt to end the “nod and wink” game played with analysts. “We are quite comfortable measuring our progress as we achieve it, instead of focusing on establishing and attaining public forecasts,” says Coke CFO Gary Fayard.

Others are likely to follow. “It’s a trend you will see a lot more of,” predicts Christian Hodges, co-founder of Ashton Partners, a Chicago financial-communications firm.

Proponents say the move will force analysts to do a better job studying companies. “It’s a great decision for Coke,” says Hodges. “It frees them to give more long-term, qualitative information.” He adds that less-specific guidance could also limit securities suits.

Not everyone is convinced, though. Chuck Hill, director of research for Thomson First Call, a financial-information firm, says the move could backfire. “If anything, it could make the focus on the short term worse,” he argues.

Hill speculates that less guidance will lead to more-frequent and larger earnings surprises, adding volatility to stock prices. “Everyone will be tuning in each quarter to hear the big surprise,” says Hill.

Instead, he advises firms to continue to give conservative guidance they are confident in. “Don’t make guesses,” he chides. “But let the facts hang out.”

Hodges agrees that a code of silence is not for everyone. “Smaller companies or those going through significant transition need to do more hand-holding with Wall Street,” he says.

(To find out more about the move to do away with earnings guidance, read “Nothing But the Real Thing.”)

The Holes in Black-Scholes

Does the Black-Scholes option-pricing model — the most common method for valuing stock-option grants — accurately forecast how much an option will be worth?

Not even close, says a study by Sibson Consulting. “Black-Scholes is not a good predictor of actual gains,” says senior vice president Blair Jones, who managed the study.

Sibson tested a broad sample of 1,445 companies during six periods between 1972 and 2002. For each period, the average actual gains as a percent of Black-Scholes value ranged from 95 percent to 910 percent. Only 3 to 5 percent of stocks were within 90 to 110 percent of the price estimated by Black-Scholes.

Odds are high that public companies soon will be required to expense stock options, which generally means Black-Scholes estimates will appear as expenses on the income statement. (The alternative binomial model is rarely used, and so far, no one has figured out how to obtain market-based prices, which are preferred under the current accounting standard.)

Both the Financial Accounting Standards Board and its overseas counterpart, the International Accounting Standards Board, are already considering expensing requirements that are likely to pass this year (see last month’s cover story “Questions of Value“).

Jones is quick to note that FASB doesn’t claim Black-Scholes actually predicts future gains — it’s simply a way of reporting an estimated cost. But, she adds, “if this cost is going to be perceived as the actual cost to the company, it is somewhat misleading. I’m not sure the average analyst or investor makes the distinction about whether this is the actual economic cost to the company or not.”

Companies should be careful how they portray Black-Scholes, says Jones, adding that they “probably shouldn’t use it in their communications [with employees].”