You know the old saying “The secret to happiness is low expectations”.
This is nowhere truer than when US companies release their quarterly earnings. Before the results came out S & P Capital Intelligence estimated an 8% drop in earnings in Q1 2016 compared to Q4 2015.
But just look at the results. JP Morgan reported first-quarter earnings of $1.35 per share on revenue of $24.08 billion, beating the analyst estimate of $ 1.26. Morgan Stanley reported first-quarter net income of $1.13 billion, or $0.55 per share, topping analysts' consensus estimates of $0.46 EPS on revenue of $7.78 billion. Citi was also able to “beat” expectations, reporting net income of $3.5 billion, or $1.10 per share; analysts were expecting an EPS of $1.06.
Over the last three months the chieftains of these mega banks have been crying out that profits will be hammered. Analysts dutifully adjusted their forecasts. This practice is called earnings guidance. And in this case it cleverly guided analysts to a lower EPS number.
In other words, keep expectations of earnings low enough and you will of course exceed that target!
The practice of earnings guidance became more common during the late 1990s, after the US Congress protected companies from liability for statements about their projected performance.
Most CFOs issue earnings guidance because they believe it improves valuation multiples, shareholder returns, reduces share price volatility and boosts liquidity.
Let’s look at the research. Way back in 2006, McKinsey & Co Consultants Peggy Hsieh, S. R. Rajan and Tim Koller published some interesting findings.
Contrary to what some companies believe, guidance does not result in superior valuations in the marketplace.
When a company begins to issue earnings guidance, its share price volatility is as likely to increase as to decrease compared with that of companies that don't issue guidance.
When companies begin issuing earnings guidance, trading volumes rise relative to companies that don't provide it. However, this rise wears off the following year. Since most companies don't have a liquidity issue, this rise in volumes is neither good nor bad from a shareholder's perspective.
But there are serious downsides to this practice.
The difficulty of predicting earnings accurately can lead to the often painful result of missing quarterly forecasts. As a result, senior managers can get paid less or even be fired. That can be a powerful incentive for management to focus excessively on the short term; to sacrifice longer-term, value-creating investments in favor of short-term results. Like cutting back on R & D and Training.
Managements also sometimes manipulate earnings to meet EPS targets. In bull markets, some companies have given optimistic forecasts when the market wants momentum stocks with fast-growing EPS. In bear markets, companies have tried to lower expectations so that they can "beat the number" during earnings season. Like in Q1 2016.
The practice has costs. Demands on management's time is the biggest cost- putting it together, analyzing and communicating- given that forecasting net income is much tougher than forecasting revenue. And there is the significant indirect cost of an excessively short-term focus.
Analysts can become less diligent due to earnings guidance. Analysts should be thorough and not expect management to do their work for them. This is one thing that I hammer home to my CFA students. It is one of the analyst's jobs to evaluate management expectations and determine if these expectations are too optimistic or too low. Sadly, this is something that many analysts often forget to do, like during the dotcom bubble.
It’s not like earnings guidance is essential for a well-developed financial market. European markets and investors have functioned just as well without much forward guidance from management.
And let’s face to beating estimates won’t pull up a bad stock, just like missing earnings will not pull down a company’s share price. Look at Netflix. In one quarter a few years ago, in spite of turning in earnings that more than doubled expectations, share price collapsed, reflecting its challenges in trying to monetize streaming videos. Or Apple a few years ago. It missed earnings in a quarter 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.
Guidance is useful only in exceptional situations, when uncertainty about your company's prospects is high.
Let’s go back to the Q 1 2016 earnings where many big banks “beat” analyst estimates. A closer look shows what really happened:
Revenues from advisory and trading fell, thanks to a plunging stock market.
Banks had to take a hit for losses due to bad loans to the energy sector, setting aside as much as -in the case of Bank of America and Wells Fargo- a billion and 200 million dollars respectively in just this quarter.
Finally banks cut costs aggressively to maintain margins
But not many analysts focused on this, instead crying out ecstatically when earnings estimates were beaten.
In a June 2014 piece in the Harvard Business Review titled “How to Kill Earnings Guidance”, Gabriel Karageorgiou, Daniela Saltzman and George Serafeim offer some useful recommendations:
Companies should scrap earnings guidance.
Companies should help the market to understand their business, the underlying value drivers, the expected business climate, and their strategy. This can be achieved by Integrated Reporting which is the process of communicating how the firm is using different forms of capital, human, financial, natural, physical, intellectual, and social to create value over the short, medium and long-term. Analysts and investors can then prepare better forecasts of earnings and value.
Companies should communicate a detailed long term business plan to the market, with financial milestones.
Coca Cola, Mattel, AT & T, McDonalds and Gillette have stopped providing earnings guidance. Let’s hope more companies are bold send sensible enough to follow.
Binod Shankar is a Chartered Accountant and CFA Charter holder. An experienced analyst and Finance Director with nearly two decades of experience in the Middle East, he co founded and now heads Genesis Institute, a leading regional financial training firm.