U.S. companies are of two minds about the wisdom of providing earnings guidance. The majority now do so, viewing the quarterly ritual as a necessary, if sometimes onerous, part of investor relations. The benefits, they hope, are lower share-price volatility and higher valuations. At a minimum, companies expect frequent earnings guidance to boost their stock’s liquidity.
But increasing numbers — Citigroup, Motorola and Intel among them — have announced that they will either minimize the practice — offering only annual guidance — or abandon it altogether in favor of more information about what drives their underlying performance and long-term health.
McKinsey research and analysis suggest that more companies should consider following their lead, as the supposed benefits simply don’t exist. Moreover, there are real costs associated with providing quarterly guidance, chief among them the time senior management must spend preparing the reports and the excessive focus it encourages on managing short-term results to hit the targets.
Our analysis of some 4,000 large companies between 1994 to 2004 found quarterly earnings guidance does not result in superior valuation in the marketplace, as some companies believe; indeed, there appears to be no significant relationship between guidance and valuation, regardless of the year or the industry. The analysis didn’t even show a temporary increase in total returns to shareholders (TRS) the year guidance commenced. Markets don’t react.
Neither did the analysis reveal a link between earnings guidance and share price volatility. Rather, it showed that the price volatility of a company that starts issuing guidance is as likely to increase as decrease compared with companies that do not issue guidance.
The research did show that when companies begin issuing earnings guidance they experience increases in trading volume relative to companies that don’t provide guidance. However, this effect soon wears off. Moreover, since most large companies don’t have a share-trading liquidity problem, the rise in trading volume is neither good nor bad from their shareholder’s perspective. Greater volume merely represents an increased opportunity for short-term traders to act on the news contained in the earnings guidance and has no lasting relevance for shareholders.
On the cost side, executives we surveyed say that the demand on management time is the biggest cost of issuing frequent guidance, followed closely by the indirect cost of an excessively short-term focus. The difficulty of forecasting earnings accurately so as to provide guidance can lead to the often painful result of missing quarterly forecasts. That, in turn, can be a powerful incentive for management to sacrifice longer-term, value-creating investments in favor of short-term results, and, in some cases, to manage earnings inappropriately from quarter to quarter to create the illusion of stability.
None of this is to suggest that companies stop communicating altogether; communication with analysts and investors is important, and voluntary disclosure of financial information is a key component of high-functioning capital markets. Rather, companies should focus on helping investors better understand the underlying business performance and what drives the longer-term health of their company, instead of fixating solely on its short-term performance.
Companies should be quite clear about what drives the underlying performance of their particular business — both recent trends and the longer-term outlook. They could, for example, describe the extent to which revenue growth was accounted for by organic or acquired growth, price or volume increases, industry or market-share growth, as well as the impact of factors such as currency changes. Looking ahead, they could discuss what is likely to drive industry growth and their ability to grow faster than the competition. On the cost side, they might distinguish between lasting productivity improvements, one-off savings, and changes in investments in marketing and research. They could also disclose any plans to help them improve their cost position relative to the competition.
Analysts could then build their own models to predict future earnings. Moreover, they would be better able to determine the impact of corporate action — for example, cost cutting, share repurchases, marketing spending, R&D, organic-growth initiatives, and M&A — on earnings, and more importantly, on long-term value.
Many executives fear that even if issuing earnings guidance doesn’t impact valuation, ceasing to do so could, as analysts will suspect that the company is hiding bad news. The evidence suggests otherwise. We analyzed 126 companies that discontinued guidance and found that they were nearly as likely to see higher as lower TRS compared with the market in the year of stopping guidance. Furthermore, the lower-than-market TRS of companies that discontinued guidance was caused by poor underlying performance and not the act of ending guidance itself.
Nevertheless, it is still important for companies that choose to discontinue issuing earnings guidance to clearly communicate that the action is not motivated by poor expectations of future performance. Rather, it is a commitment to creating long-term, sustainable shareholder value that investors will hopefully share. The trend of more and more companies discontinuing quarterly guidance and substituting thoughtful disclosure about long-range strategy and business fundamentals is a healthy one.
About the Authors
Tim Koller is a partner and S.J. Rajan is a consultant in McKinsey’s New York office.