Tuesday, 10 March 2009

Earnings Guidance - Good or Bad ?

The Economist , in its Feb 28th issue, carries a leader "To forecast or not to forecast" ? It warns its readers to be beware of firms that refuse to issue annual forecasts. The trigger was the recent announcements by a few companies that they would not give an earnings guidance for 2009, citing the turbulent times. The article, as all Economist articles are, is very well written with cogent arguments and well worth a read, even if you don't agree with its conclusions.

Providing guidance to the market is now widely practiced and expected of all companies. As investors push for greater and greater transparency into the company, guidance requirements have become very detailed and at shorter time intervals, usually quarterly. Companies are expected to meet their guidance numbers - companies and managements are punished severely if they don't. Prior to results announcements, there's a veritable frenzy of speculation on results with analysts falling over themselves to announce their expectations. Share prices are prone to violent fluctuations if the actual results are off from the guidance either way.

When companies are doing well, they rush to give guidance and talk up their share prices. Its when companies are not doing well that you hear moaning about how these expectations are unrealistic and how its all unfair to expect quarterly forecasts. The current downturn is an opportunity for many companies to escape the yoke of guidance and its reasonable to expect many more companies to take advantage of this opportunity.

The case for guidance is that investors are entitled to understand what the company is aiming for and what it expects to deliver. This is an important constituent of valuing the company fairly. After all every company has a detailed budgeting process internally. Giving some transparency to this for the investors is part of good stakeholder management.

The case against guidance is strong as well. Because of the severe penalties of missing a guidance, there is every incentive for management to massage results as close as possible to the forecast. The premium on quarterly numbers also promotes short termism. The whole process of providing guidance has degenerated into expectations management - its more important to set expectations properly and "manage" them rather than actually deliver outstanding performance. A whole Investor Relations industry has thrived in this atmosphere. There is also the trap of too much guidance that is expected - listen to any earnings call of any company and see the extreme detail into which some analyst is probing. What he is trying to do is to fill his valuation spreadsheet of course, but the company is expected to make ridiculously detailed forecast which is meaningless anyway.

Where is the balance ? I believe the pendulum has swung to too much forecast and too much detail. Its perhaps time to correct this balance, using the opportunity of uncertain times. An annual forecast range of top line and bottom line should be adequate with some details on major business lines. A range is better than a headline number, which is spurious accuracy anyway. At quarterly results time, there would be details of actual performance . That's it. Nothing more.

As The Economist says, " here is one forecast for 2009 that is certain to come true : investor relations departments will be busier than ever" !


Prince said...
This comment has been removed by the author.
Prince said...

Ramesh, well expressed; With the present quarterly reporting requirements, your suggestion of a broader annual forecast of the planned top and bottom lines is a good guideline. Trying to forecast beyond 12 months is nice to have but below threshold reliablity in the present complex competitive times. Even as we run the business, an annual forecast with quarterly updates on the annual guideline is the best background for investors to work on. I also like your suggestion on a range. The company works on a set of assumptions and the probability of all these events happening is just about as likely as not. In the interest of the investor, a range can adequately facilitate shareholder decision making and let management get on with the more important task of delivery. I only hope as a fallout of this, the Audit Committee is not saddled with whetting of the guidance nor the auditors asked to add a further comment in the Audit Report !! We need to take this forward in our own spheres

Ramesh said...

Thanks Prince. Your fear of the Audit Committee being roped is something I hadn't thought of, but could very well be real.

Follow by Email

Blog Archive

Featured from the archives