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
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
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
On the flip side, even beating expectations is no guarantee of success, as video rental giant Netflix
It's not just bad guidance that can temporarily pull down a stock. Medical device company Abiomed
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.
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.
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