Can Earnings Guidance Accurately Predict The Future?

Earnings guidance" is a relatively new term that describes an old practice of predicting the future (in this case in regard to business expectations). But new regulations have changed how this information is given to the market. Some companies are now saying they will stop giving guidance to combat the market's focus on the short-term, but could it be because of the potential liabilities the companies face? This article will provide a perspective on this age-old tradition, discuss the good and bad points, and examine why some companies are saying "no more" to earnings guidance.

Earnings Guidance Defined
Earnings guidance is defined as the comments management gives about what it expects its company will do in the future. These comments are also known as "forward-looking statements" because they focus on sales or earnings expectations in light of industry and macroeconomic trends. These comments are given so that investors can use them to evaluate the company's earnings potential. (To read further on earnings, see Everything You Need To Know About Earnings, A Case Study: Earnings Manipulation And The Role Of The Media and Target Prices Vs. Ratings.) 

An Age-Old Tradition
Providing forecasts is one of the oldest professions. In previous incarnations, earnings guidance was called the "whisper number". The only difference is that whisper numbers were given to selected analysts so that they could warn their big clients. Fair disclosure laws (known as Regulation Fair Disclosure or Reg FD) made this illegal and companies now have to broadcast their expectations to the world, giving all investors access to this information at the same time. This has been a good development.

The Good: More Information Is Always Better
Earnings guidance serves an important role in the investment decision-making process. Under current regulations, it is the only legal way a company can communicate its expectations to the market. This perspective is important because management knows its business better than anyone else and has more information on which to base its expectations than any number of analysts. Consequently, the most efficient way to communicate management's information to the market is via guidance. In an ideal world, analysts would use this information in combination with their own research to develop earnings forecasts.

The Bad: Management Can Manipulate Expectations
The cynical view is that, because this is not an ideal world, managements use guidance to sway investors. In bull markets some companies have given optimistic forecasts when the market wants momentum stocks with fast-growing earnings per share (EPS). In bear markets companies have tried to lower expectations so that they can "beat the number" during earnings season. It is one of the analyst's jobs to evaluate management expectations and determine if these expectations are too optimistic or too low, which may be an attempt at setting an easier target. Unfortunately, this is something that many analysts forgot to do during the dotcom bubble.

Why Some Companies Stopped Giving Guidance
Claiming that guidance promotes the market's focus on the short term, some companies have said they will stop providing guidance in order to try to combat this obsession with the short term. While this may sound noble, they can't seriously think this will be effective.

Eliminating guidance will not change the market's fixation on the short term because the market's incentive policies cannot be dictated. Coke could stop talking to everybody, but there would still be a score of quarterly estimates on First Call. Why? Because that is what institutional investors want. The Street will remain focused on the short term because that is how it is compensated. Everyone on Wall Street is paid annually and gets paid more if he or she outperforms in that year. This focus will not change if companies don't talk to the Street.

The real reason why some companies have stopped giving guidance is probably a legal one. In this post-bubble, litigation-happy environment, eliminating guidance will avoid potential liability expenses. It will also allow management to spend more time on running the company because it won't have to answer guidance questions anymore.

The Ugly: Eliminating Guidance Will Increase Volatility
Eliminating guidance will result in more diverse estimates and missed numbers. Analysts often use guidance as a reference point from which to build their forecasts. Without this anchor, the range of analysts' estimates will be wider, producing larger variances from actual results. Misses of more than a penny may become commonplace.

An interesting question is what will the Street do if misses become bigger and more frequent? Today, if a company misses the consensus estimate by a penny, its stock could suffer or soar, depending on whether the miss was negative or positive. Bigger misses could result in bigger swings in stock prices, producing a more volatile market. On the other hand, if the market is aware that the misses are caused by the lack of guidance, it may become more forgiving. If there is an argument for stopping guidance, it is that the Street would be more forgiving of companies that miss the consensus estimate.

The Bottom Line
Guidance has a role in the market because it provides information that can be used by investors to analyze the company, evaluate management and create forecasts. Companies are foolish if they think they can alter the market's short-term focus. The Street will still do what it wants, and it will stay focused on quarterly timelines. If, however, more companies opt for no guidance, the Street inadvertently may become more rational and therefore stop whipsawing stock prices for miniscule variances that are really just SWAGs (Systematic, but We're All Guessing).

by Rick Wayman, (Contact Author | Biography)