Providing quarterly earnings guidance to Wall Street is widely criticized for consuming an inordinate amount of time, rarely hitting the bull’s-eye, and unnecessarily shifting a company’s focus to short-term tactics at the expense of long-term value. Yet most CFOs still put their shoulders to the effort. Is it really worth it?
Those who would answer yes would agree with Chad Stone, CFO of Renewable Energy Group, a Ralston, Iowa-based biodiesel fuel producer. “Offering an indication of our expected performance creates an opportunity for investors and analysts trying to understand and model our business,” says Stone. “The absence of shared quarterly guidance would make it difficult for the investment community to understand how the business will perform in certain market conditions.”
Yet, a number of public companies have stopped giving quarterly guidance and have found they are better off for it. Over the past half-dozen years, such brand-name companies as Costco, Ford, UPS, Coca-Cola, AT&T, Berkshire Hathaway, and Google have given the thumbs-down to regularly positing quarterly forecasts. Even newly minted public corporations fresh from their initial public offerings are skipping the workout.
“We used to provide quarterly guidance, but when the financial turmoil hit and we lost confidence in our estimates, we migrated to annual guidance,” says Kurt Kuehn, CFO of Atlanta-based global shipping company UPS. The company hasn’t gone back. “It’s been a good fit,” says Kuehn.
The same fit suits Strategic Hotels & Resorts. “Personally, I don’t believe in quarterly guidance, because it is too short-term focused,” says Diane Morefield, executive vice president and CFO of the Chicago-based owner of 18 luxury properties across North America and Europe. “I would simply hate being boxed in by guidance every three months.”
Still, many public companies remain firm believers in short-term guidance. According to a recent survey of its members by the National Investor Relations Institute, 76% provide financial guidance; of those, 37% give quarterly earnings/EPS guidance, and 39% give quarterly revenue guidance. At the same time, the percentage of NIRI’s members who provide some kind of financial guidance has fallen over the past few years, from 81% in 2010 and 85% in 2009.
Is this a trend? NIRI president and CEO Jeffrey D. Morgan isn’t certain. “I believe it’s primarily a result of the economic downturn over this period,” he says. “Public companies want to be transparent and provide as much information as possible to help the market value them appropriately. Since about 2008, it’s been more difficult for companies to forecast” — hence the move away from guidance.
While uncertainty about how a quarter will play out is a good reason to give up guidance, McKinsey & Co. cites several other reasons. Weighing the pros and cons of quarterly earnings guidance in a 2006 study, the management consulting firm unveiled an analysis of 4,000 public companies indicating that quarterly earnings guidance does not result in superior valuation in the marketplace, as many CFOs believe. “There appears to be no significant relationship between guidance and valuation, regardless of the year or the industry,” the McKinsey authors stated.
While McKinsey’s research cited increases in trading volume among companies that issued quarterly guidance (compared with those that did not), the effect soon wore off. And if predictions missed the mark, the authors wryly noted the “disdain” companies received from analysts. Their conclusion: the practice provided scant value, imposed a direct cost in management time, and fostered excessive short-term focus.
“Culture of Fear”
The latter criticism is echoed by several business- and law-school academics. Quarterly guidance “makes companies do everything for the short term,” says Ed Hess, professor of business administration and Batten Executive-in-Residence at the University of Virginia’s Darden Graduate School of Business. “Management makes decisions for the short term, employees are thinking solely about the short term, and investments are made for the short term.”
When this occurs, a “culture of fear” takes over, Hess contends, “eroding cognitive processes, judgments, and innovation to the detriment of long-term value creation. Your employees and customers start believing you don’t care about them, you’re just in it for the stock options. I favor eliminating the practice [of guidance].”
He is far from alone in his arguments. “Companies are so caught up in hitting the forecast, they do everything they can not to miss it,” says Robert Mittelstaedt, dean and professor of management at Arizona State University’s W.P. Carey School of Business. “This, in turn, compels a myopic focus on the short term, taking people’s eye off long-term shareholder value — the real value.”
“The [stock] market is based on expectations, and the typical investor and analyst want to base those expectations on some signals from the company,” comments Scott Fine, professor of banking and finance at the Weatherhead School of Management at Case Western Reserve University. “The problem is that what we know best is what is closest to us. You have visibility into the order book and the supply chain, and you extrapolate from this in the quarterly forecast, even though you can’t predict two months away. All you’re doing is emphasizing uncertainty and focusing on the short term.”
Not so, counters Ed Barrows, a partner at consultancy Cambridge Performance Partners. “The conventional thinking suggests that companies shouldn’t issue quarterly guidance, so they can focus on long-term value creation. But if a company can’t estimate its performance over the next quarter, how can it be expected to manage value over the long term?” asks Barrows. “Well-managed companies do both.”
Morgan of NIRI says that ending guidance is simply unrealistic. “Wall Street demands this information,” he says. “Analysts will continue publishing forecasts, and companies will be held to these forecasts by the financial-media outlets that breathlessly report whether a company beats or misses analysts’ forecasts — as if this were a game, and the incredible complexity of a company’s operations could be boiled down to a single figure every three months.”
Professors Fine and Mittelstaedt concur that there is tremendous pressure to issue guidance, and tremendous anxiety about not doing so. “If you provided it before and don’t do it now, you’re afraid that investors and analysts will think you’re hiding something,” Mittelstaedt says. Fine comments that a “typical investor wants information on a company from every source he or she can find it, and quarterly earnings guidance is one of those sources. For many organizations, it’s simply become a necessary evil.”
It doesn’t have to be, says Hess: “CFOs need to have the guts to say, ‘No more,’ to say to Wall Street, ‘We’re just not going to play this made-up game anymore, we’re in this for the long term.’”
Not Going to Give It Anymore
Several CFOs of public companies have done just that. “We do not believe in managing our business for the short-term,” says Ellen C. Wolf, senior vice president and CFO of American Water, a Voorhees, New Jersey–based water and wastewater utility company. American Water issues annual guidance (a range of earnings per share) and updates it during the year. “What is important is how the market reacts to misses on quarterly guidance,” says Wolf. “Often that short-term reaction forces some companies to take short-term actions that don’t always lead to long-term sustainable value. We are a long-term investment.”
Not surprisingly, unpredictability in a company’s business can make guidance undesirable. “We provide annual guidance to the Street because we feel there is enough variability in our business environment on a quarter-to-quarter basis that it’s unhealthy for us to pin ourselves down to one quarter’s guidance,” says Robert Fugate, executive vice president and CFO of Cbeyond, an Atlanta-based provider of infrastructure-as-a-service and communications services.
“Annual guidance gives us a way to provide investors with markers that they can judge us by on an appropriate time basis,” Fugate adds. “This provides me, as a CFO, with the ability to give the strategic-level view and not be swayed by quarterly swings.”
Home-phone service provider Vonage also provides annual earnings guidance and what CFO Barry Rowan calls “quarterly checkpoints against our long-term plan.” Rowan compares the latter to grading elementary-school students. “Short-term goals and objectives can be comparable to assignments and projects throughout the year, with the long-term goal being your overall grade,” he explains. “The quizzes, tests, and midterms keep the pressure on students to perform consistently from start to finish.”
At Costco, both quarterly and annual earnings guidance are gone, a decision the company reached three years ago. The giant retailer posts monthly sales figures — enough for Wall Street to get a far better picture of how the company is progressing than earnings estimates can provide, says CFO Richard Galanti. “Back in the thick of the financial crisis, even companies that offered the most accurate quarterly guidance for decades were caught unawares by the sheer volatility of the event,” he says. “It just made little sense to continue the process.”
Another factor in eliminating the guidance exercise was the impact on workers caused by the topsy-turvy nature of the stock market. “We’d miss our projections by a few cents one quarter, suffer the consequences in the market, and get our employees worried about their performance-based compensation,” Galanti recalls. “Then, the first month into the new quarter we’d be doing gangbusters, but we now had another two months to go before we reported.”
Admittedly, not every organization that has ditched quarterly forecasts says the decision is absolute. “There can be exceptions to not providing quarterly guidance in special circumstances,” concedes Morefield of Strategic Hotels & Resorts. She cites “unusual or material events” that may cause the company to miss consensus estimates in a given quarter. Such circumstances may require the company to “provide color” on the situation in advance of actual earnings, she explains.
The upshot for CFOs is clear: when a truly disappointing quarter looms, raising a red flag is better than ducking under the covers.
Russ Banham ([email protected]) is a contributing editor of CFO.
New Forms of Guidance
A number of companies are shifting from quarterly earnings guidance to annual guidance with quarterly updates, according to Tim Koller, a partner in McKinsey’s New York office and head of the consulting firm’s Corporate Performance Center. “This gives them more flexibility quarter to quarter,” he says. “They don’t have to go through all kinds of gyrations.” Other firms are turning to more operational types of guidance. “They might say, for example, in the next three to five years we expect revenue growth to be in a range from 3% to 5%, leaving it up to investors to construct their own analyses,” says Koller.
Industry-specific forecasts are catching on. Some oil companies, for example, are indicating how much oil they will produce, says Koller. “Rather than EPS numbers, it’s the underlying drivers of the business,” he says. “With financial institutions, we’re seeing some of the better companies giving their aspirations for return on equity in a line of business, such as 15% ROE.”
McKinsey expects that more and more companies will move away from providing quarterly earnings and revenue guidance, says Koller. “Most CFOs and CEOs don’t like it or feel it is helpful,” he says. “They feel like they have to do it, but as more companies don’t do it, others are gaining the confidence to stop the practice, or to shift to providing broad ranges as opposed to hitting a particular number. This way there is more room in there in case of a mistake. And they’re at least providing some guidance as opposed to none.” — R.B.
Guidance and Earnings Quality
Does the pressure to meet earnings forecasts prod companies into manipulating their numbers? Andrew C. Call, an assistant professor at the University of Georgia’s Terry College of Business, says this common perception isn’t borne out by the evidence. “Our findings suggest that managers who issue short-term earnings guidance are actually less likely, not more likely, to engage in accounting shenanigans,” says Call, co-author of a recent study on short-term earnings guidance and earnings management.
Using abnormal accruals as a proxy for earnings management, the study found that companies that issue short-term earnings guidance have significantly lower abnormal accruals than companies that don’t issue guidance. The authors surmise that managers who issue earnings guidance are able to guide investor expectations to their earnings, and thus have less need to resort to accounting shenanigans in an effort to avoid an earnings surprise. — R.B.