Why Quarterly Earnings Guidance Should End

Worldwide Invest Better Day 9/25/2012

One of the most destructive things many companies do is to provide guidance to Wall Street about how the current quarter and the near-term future will turn out. It's destructive because the moment a company's executive states an earnings target, meeting that target typically becomes way more important than virtually anything else.

After all, there's more than just their reputation on the line. According to a Harvard Business School study, C-level officers who missed guidance were more likely to feel it in their pocketbooks, thanks to penalties ranging from lower bonuses to outright dismissal. A little pressure can be a good thing, of course. Unfortunately, though, when the choice becomes "make the numbers" or "build the business" and the penalty for missing the numbers can be termination, the long-term business generally suffers.

Game theory and earnings guidance
To make matters worse, to the jaded analysts on Wall Street, guidance becomes something of a game. "Whisper numbers" of what the analysts really think will happen become based on not only the company's guidance but the company's history of meeting, beating, or falling behind that guidance. And those analysts are no dummies, either -- they know the historical practice of "cookie jar accounting" and the still-legal ways to "pull forward" sales through practices like limited-time deep discounting.

Automakers are the masters of such pull-forward practices, with General Motors (NYSE: GM  ) routinely turning in sales numbers that are aided by dealer inventory builds. Or in other words, many of those sales count as sales from the manufacturer's perspective, even though they don't immediately make it to the hands of actual consumers.

As a result of all that, earnings guidance itself often winds up saying less about the company's prospects than it does about how good management is at pulling the right accounting levers to reach its targets. Indeed, the analyst decision tree begins to look something like this:

If a Company...

Then the Analysts...

Fails to meet guidance Wonder how bad it must really be, since the company clearly ran out of levers to pull.
Meets guidance Start questioning whether the company is aggressively building the business or simply managing to expectations.
Beats guidance Begin assuming management was "sandbagging" by providing low guidance it could easily beat.

There really is no winning outcome from providing guidance, so the real question becomes: Why bother delivering it? Indeed, after earnings are reported, regardless of whether they meet, beat, or fall below expectations, a company's stock can move in virtually any direction at all.

Which way did they go?
Sure, you'll find cases in which companies are punished for failing to meet expectations. Big Lots (NYSE: BIG  ) saw its shares pummeled last month when its results fell short of targets. In a business like Big Lots that depends on closeout merchandise, it's often tough to predict the future since so much of its success depends on other companies' overproduction rather than its own innovation.

Still, if you take a step back from the immediate consternation, even missing earnings doesn't necessarily doom a company to failure. For instance, titan Apple (Nasdaq: AAPL  ) missed earnings in July and saw its shares immediately stumble on the news. Yet the very next month Apple's shares raced to an all-time high after a court ruled in its favor in a patent dispute with Samsung. So clearly, missing earnings doesn't doom a company to long-term failure -- as long as its business is fundamentally strong.

On the flip side, even beating expectations is no guarantee of success, as video rental giant Netflix (Nasdaq: NFLX  ) found out when it most recently reported earnings. In spite of turning in earnings that more than doubled expectations, its weak outlook on the back of its challenges in trying to monetize streaming videos slammed its stock. As with Apple, Netflix showed that over time the fundamental strength (or lack thereof) of the business, not its ability to hit this quarter's numbers, matters most.

It's not just bad guidance that can temporarily pull down a stock. Medical device company Abiomed (Nasdaq: ABMD  ) beat expectations last month and raised the low end of its guidance, only to see its shares quickly fall on the news. The stock later slumped on the news of the death of its founder, but has since mostly recovered on both the strength of its business and persistent takeover speculation.

What if they get it right?
Perhaps worst of all, companies that are successful enough at the guidance game to keep doing it tend to develop a case of shortsightedness that often leads to underinvestment in their businesses. After all, the "easy" expenses to cut are often things like research and development that don't necessarily provide near-term benefits but do drive long-term growth.

With a decreased focus on the things that drive long-term growth, the long-term returns for shareholders are diminished. After all, over time, your investment returns are determined largely based on how far and fast a company grows and how much value it directly returns to you via dividends and intelligently priced buybacks. Everything else -- including whether it met, beat, or fell behind last quarter's earnings expectations -- falls out as mere noise in the inexorable march of time.

The only winning move is not to play
So why bother guiding? If the best you can hope for is mediocre growth driven by managing the business to meet expectations rather than working to generate long-term value, is that really a prize worth winning? This investor would much rather see the short-term volatility and surprises -- both positive and negative -- that come from managing the business for long-term value creation.

Stability is nice, but if predictable cash flows were all that mattered to investors, there are other forms of investments -- like investment-grade bonds -- that would be a better place to invest than stocks.

At the time of publication, Fool contributor Chuck Saletta did not own shares of any company mentioned in this article. Click here to see his holdings and a short bio.

The Motley Fool owns shares of Apple and Netflix. Motley Fool newsletter services have recommended buying shares of Netflix, General Motors, and Apple, as well as creating a bull call spread position on Apple and a bear put ladder position on Netflix. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (17) | Recommend This Article (40)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 07, 2012, at 7:32 PM, csqrd wrote:

    As long as analysts will continue to guess at quarterly earnings, the argument against company guidance is compelling. I would hate to miss the buying opportunities created by "misses" to earnings expectations when the company profitability, growth rates, and execution of their strategic plan is still going strong. When the market punishes a miss of a penny or two it can be an ideal opportunity to add to a position. Let the games continue.

  • Report this Comment On September 08, 2012, at 1:10 PM, hightimes1 wrote:

    Mr. Saletta, you've well described one of the most troublesome of the many troublesome practices resorted to by these so called analysts (talking heads, the far better term). This is an excellent example of just how often they do more harm than good for and to the market and the investor, and how they actually disrupt the generally and naturally occuring, efficent pricing of the market. As difficult as it can be for serious, information seeking investors to tune them out, it seems that the most successful of investors have found a way to do just that. Does the name Warren Buffet ring a bell?

  • Report this Comment On September 08, 2012, at 2:48 PM, jc09058 wrote:

    Good article. Guidance can be best described as playing darts while being blindfolded and given only general directions on where the bulls-eye might be located. Any chance of a bulls-eye (guidance being correct) is due to pure absolute luck or a company that has absolutely no external or internal influences on its production or service.

    The company I describe above would be referred to as a "Purple Squirrel" company. The company doesn't exist because there are no purple squirrels, and every company in existence has internal influences (people) that are prone to changing things because they can and feel they have a "better" idea.

  • Report this Comment On September 08, 2012, at 3:32 PM, crinnis wrote:

    Couldn't agree more. As a senior member of an intl Oilco we got caught in this quarterly crap. Talk about driving ridiculous behaviours!!

    During that time (2000-2004) Exxon remained utterly aloof! Well done them.

  • Report this Comment On September 08, 2012, at 3:36 PM, kmtominey wrote:

    You are so right - the only thing that will stop it though is for the laws to be changed to make it illegal.

    Not sure the gutless wonders in DC are up for that.

  • Report this Comment On September 08, 2012, at 4:05 PM, colleran wrote:

    AMEN, AMEN, AMEN!

  • Report this Comment On September 08, 2012, at 6:56 PM, pfxg99 wrote:

    As an investor relations consultant, let me tell you the little secret about why most companies give guidance. Because if they didn't, analysts would way too often be way off the mark in their estimates, creating unwanted volatility. Most of the companies that have backed off of guidance (temporarily or permanently) have done so because they themselves realized they were not able to be very accurate due to their nature of their business, seriously difficult economic conditions, etc.

  • Report this Comment On September 08, 2012, at 7:34 PM, jomueller1 wrote:

    Agree, the quarterly guidance is a miserable thing. I understand that "analysts" are guided so that they come somewhat close to reality. But that is just another form of manipulation. The analysts don't really do their job, they parrot what they hear. That's why "analysts" are the kind of people I never listen to. In fact, the world would be better off without them.

    The "analysts" existence is a relic from olden times, when communication was poor and the guy in NY did not know what was happening in SF. So he bought a service. Now there are so many "analysts" eating from the same buffet and yet cannot come up with some sensible reports.

    Part of their reason to exist is the US impatience and lack of attention span. Rather have it fast than right.

  • Report this Comment On September 08, 2012, at 8:12 PM, mogulbangr wrote:

    I worked on Wall Street for several years, and learned that the analysts all drink each other's bath water. Their "advice" is absolutely worthless. If they forecast lower earnings, the company PR people stop talking to them. If they don't express an opinion their employers fire them. Who was it who said "Economic forecasts exist only to make astrology look respectable." Ditto for earnings forecasts.

  • Report this Comment On September 09, 2012, at 7:18 AM, Mathman6577 wrote:

    Good article. I agree. Information overload is bad when it comes to stocks.

    Warren Buffett always said you can get most of what you need out of the annual reports and proxy statements. You don't need information 4 times a year.

  • Report this Comment On September 09, 2012, at 7:21 AM, PaulEngr wrote:

    The problem isn't the company releasing guidance. It's the over reliance on so called analysts. In information published by David Dreman there is a very nice chart that shows that analysts generally tend to "predict" that in all cases regardless of the fundamentals of the business, they will predict no change in the business at all...basically they aren't analyzing.

    Second there's another chart that shows that when companies are generally overvalued the stock price drops significantly more than it goes up based on earnings "surprises", and vice versa.

    The data itself is old and the problem has gotten significantly worse. I have found that I can make a significant amount of money simply by doing actual stock analysis and predicting when a company is significantly over/undervalued and then betting against the analysts. Instead of waiting months or years like I used to doing value investing, I get my stock movements in weeks or months. In the last 2 weeks I bought a stock for instance at $2.50 that was severely undervalued. I estimated around $3.50 to $4.00. Based on a "surprise" and nothing else, it instantly went to my predicted sell price point less than a week later. I of course sold for a tiny 50% profit. It I annualize that kind of silliness, I get a 600% per year return. It's an outlier I admit but this seems to be a consistent pattern.

    Actually, scratch that. I would far rather that the analysts keep doing what they do...not analyzing, and that the market keeps doing what it does...believing them. If it wasn't for this silliness the current level of volatility would not exist and it wouldn't be so pathetically easy to "beat the market".

  • Report this Comment On September 10, 2012, at 9:23 AM, BMFPitt wrote:

    I say keep it, because if a good company misses it by $0.01, then that creates a buying opportunity when people sell off irrationally.

  • Report this Comment On September 10, 2012, at 3:39 PM, sheldonross wrote:

    Exactly BMFPitt

    Case in point at the moment, INTC. lowered guidance and the stock is down 10%. I'll be picking up more shares shortly.

  • Report this Comment On September 10, 2012, at 8:53 PM, thecrap0n wrote:

    I also think they should just announce earnings once a year. This might lead to larger gaps, but it'll one night a year you need to worry instead of fretting about it 4 times a year.

  • Report this Comment On September 11, 2012, at 12:22 AM, maniladad wrote:

    thecrap0n: ...it'll one night a year you need to worry instead of fretting about it 4 times a year.

    I have a secret for you: All of the worrying or fretting you can do will not change the earnings, revenues, guidance or stock price direction.

    Better to spend your energy reviewing your information on the company and considering what you will do in response to various outcomes. For example, if the company is still good and the data are down from the anal-ysts' guesses you can hold on, maybe buy more if the price drops, or you can sell with the expectation that there will be a significant drop and you can buy back in at a better price. Whatever you decide to do is less critical than the fact that you have a plan. Sometimes you'll be right, sometimes wrong but at least you won't have to lose sleep fretting.

    This is a specific application of a general life lesson that I took decades to learn: Don't worry. Plan.

    D

  • Report this Comment On September 11, 2012, at 2:04 AM, kahunacfa wrote:

    From 1985 - 1992 I used to be a Sell-side technology company analyst with several different firms. My focus on analyzing the companies I followed was always on the company's technology and the products produced using that technology. My focus on earnings estimates was always on the full year numbers. The BUY side of the street always forced having to produce quarterly estimates, however.

    Some companies would provide "guidance" others would not provide guidance. Whether or not the companies provided guidance made little difference to me. The estimates I produced and published were my independent estimates based solely on my own Independent research and information sources I developed over the years of working with each company I followed.

    I always tried, with some fairly consistent success, to be exactly right with my estimates of earnings. Occasionly, a company would call me and explain for one reason or another why the company was unlikely to achieve my estimate for a particular quarter. I then would take this guidance into account and "shave" an estimate or two before the numbers were reported.

    As an Buy-side or a Sell-side analyst I always hated the quarterly estimate game or dance. That dance unfocussed what should have always been the main issue <b>How was the company's Business performing</b>?

    Kahuna, CFA

    Investment Professional

    1974 - Present

  • Report this Comment On September 14, 2012, at 1:23 PM, chris293 wrote:

    Knowledge, timing, and the benefits of honest accounting help keep you and I ahead of the game by having regular reports on the status of public companies. This passing of laws is to end quartly reports sounds hairbrained. Worry never solves anything.

    In investing numbers matter.

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