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The
misguided practice
of earnings guidance
Companies provide earnings guidance with a variety of expectations—and most of them don’t hold up.
Peggy Hsieh, Timothy Koller,and S. R. RajanMost companies view
the quarterlyritual of issuing earnings guidance as anecessary, if sometimes onerous, part of communicating with financial markets.The benefits, they hope, are lower shareprice volatility and higher valuations.At the least, companies expect frequentearnings guidance to boost their stock’sliquidity.We believe that they are misguided. Ouranalysis of the perceived benefits of issuingfrequent earnings guidance found noevidence that it affects valuation multiples,improves shareholder returns, or reducesshare price volatility. The only significanteffect we observed is an increase in tradingvolumes when companies start issuingguidance—an effect that would interestshort-term investors who trade on the newsof such announcements but should be of little concern to most managers, except incompanies with illiquid stocks. Our recentsurvey
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found, however, that providingquarterly guidance has real costs, chief among them the time senior managementmust spend preparing the reports and anexcessive focus on short-term results.These results pose an intriguing question:if issuing guidance doesn’t affect valuationsand share price volatility, why should acompany incur the real costs of issuing itmerely to satisfy requests from analysts?Our conclusion: to maintain good com-munications with analysts and investors,companies that currently provide quarterlyearnings guidance should shift their focusaway from short-term performance andtoward the drivers of long-term companyhealth as well as their expectations of futurebusiness conditions and their long-rangegoals.
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Companies that don’t currentlyissue guidance should avoid the temptationto start providing it and instead focuson disclosures about business fundamentalsand long-range goals.
A dearth of benefits . . .
The practice of issuing earnings guidancebecame more common during the latter half of the 1990s, after the
US
Congress protectedcompanies from liability for statements abouttheir projected performance.
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Since then,the number of companies issuing quarterlyor annual guidance has increased—thoughin recent years the trend has begun toslow. Our review of approximately 4,000companies with revenues greater than$500 million found that about 1,600 hadprovided earnings guidance at least once inthe years from 1994 to 2004. The number of companies that did so increased from only92 in 1994 to about 1,200 by 2001, whenthe rate of growth leveled off. The number of companies in our sample that discontinuedguidance has also increased steadily, growingto about 220 in 2004 (Exhibit 1).In our survey, executives attributed severalbenefits to the practice of providing earningsguidance, including higher valuations, lowershare price volatility, and improved liquidity.Yet our analysis of companies across allsectors and an in-depth examination of two mature representative industries—consumer packaged goods (
CPG
) andpharmaceuticals—found no evidence tosupport those expectations. The findings fellinto three categories:
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“Weighing the pros and cons of earningsguidance: A McKinsey Survey,”
The McKinseyQuarterly,
Web exclusive, February 2005 (www.mckinseyquarterly.com/links/21063). Thesurvey’s respondents included 124
CFO
s,
CEO
s,and board members from around the world,from nine industries and companies ranging insize from $10 million to $30 billion.
2
Richard Dobbs and Timothy Koller, “Measuringlong-term performance,”
McKinsey on Finance
,Number 16, Summer 2005, pp. 1–6. (www.mckinseyquarterly.com/links/21167).
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The Private Securities Litigation Reform Actof 1995.
2McKinsey on Finance
Spring 2006
Valuations.
Contrary to what somecompanies believe, frequent guidance doesnot result in superior valuations in themarketplace; indeed, guidance appearsto have no significant relationship withvaluations—regardless of the year, theindustry, or the size of the company inquestion (Exhibit 2).
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From 1994 to 2004the median multiples for consumer-packaged-goods companies track one another fairlyclosely, whether or not they issued earningsguidance. While the median multiple forcompanies that did issue guidance washigher from 2001 to 2004, the underlyingdistribution of multiples for both groupswas comparable. Indeed, the averagesof the two distributions are statisticallyindistinguishable. Our findings are similarin other industries, though their smallersample sizes create more scattered data.Moreover, in the year companies beginto offer guidance, their total returns toshareholders aren’t different from thoseof companies that don’t offer it at all(Exhibit 3). When we compared the
TRS
of
CPG
companies in the year they startedproviding guidance with that of peers thatdidn’t issue it, the distribution of excessreturns
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was centered around zero. Thisanalysis supports our finding that themarket has no reaction to the initiation of guidance. The absence of excess returns alsoholds for the year after guidance starts.
Volatility.
When a company begins to issueearnings guidance, its share price volatility isas likely to increase as to decrease comparedwith that of companies that don’t issueguidance. We looked at the ratio of thestandard deviation of monthly
TRS
in theyear of initiating guidance to the previousyear and found virtually no differencebetween companies that do or don’t offer it.Of 44
CPG
companies that began offeringearnings guidance, 21 experienced increasedvolatility and 23 showed a decreasecompared with companies that don’t offerit. What’s more, the findings were similarregardless of company size.
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Liquidity.
When companies begin issuingquarterly earnings guidance, they experienceincreases in trading volumes relative tocompanies that don’t provide it.
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However,the relative increase in trading volumes—which is more prevalent for companies withrevenues in excess of $2 billion—wears off the following year. Since most companiesdon’t have a liquidity issue, the rise intrading volumes is neither good nor badfrom a shareholder’s perspective. Greatervolumes merely represent an increasedopportunity for short-term traders to act onthe news of the earnings guidance and haveno lasting relevance for shareholders.
. . . but real costs
Analysts, executives, and investorsunderstand that the practice of offeringquarterly earnings guidance can have
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We analyzed companies by size—small($500 million to $2 billion), medium($2 billion to $5 billion), and large (greaterthan $5 billion)—and by industry, includingconsumer packaged goods and pharmaceuticals.
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Excess returns in this case are defined as the
TRS
of a company issuing guidance minus themedian
TRS
of companies in the same industrynot issuing guidance.
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Although increases in volatility were larger thandecreases among small and midsize companies,the sample was too small to warrant strongerconclusions.
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We determined the relative effect by comparinga trading-volume index for the guidingcompany to the median index for nonguidingones in the same sector. The index wascreated by dividing the trading volume in theyear guidance started (normalized by sharesoutstanding) by the trading volume in theprevious year.
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intangible costs and unfortunate, unintendedconsequences. The difficulty of predictingearnings accurately, for example, can lead tothe often painful result of missing quarterlyforecasts. That, in turn, can be a powerfulincentive for management to focus excessiveattention on the short term; to sacrificelonger-term, value-creating investments infavor of short-term results; and, in somecases, to manage earnings inappropriatelyfrom quarter to quarter to create the illusionof stability.The practice also bears hard costs. In oursurvey, executives ranked the demands onmanagement’s time as the biggest cost of issuing frequent guidance, followed closelyby the indirect cost of an excessively short-term focus. Respondents also cited demandson employees as a cost.
The risks of not providing earningsguidance
Of course, some investors would say that
not
issuing guidance can have real costs aswell. On February 1 of this year, Google,the Internet search engine highflier, sawits shares tumble by 7 percent when itsfourth-quarter results fell short of the loftyexpectations bandied about in the daysleading up to the release. Some investorsblamed the sell-off on Google’s refusalto issue guidance that might have keptexpectations in check.Still, while most companies do offer quarterlyguidance, a number of respected and highlyvisible companies have announced that theywill either minimize the practice—offeringonly annual guidance—or abandonit altogether in favor of longer-rangeindications of their strategy and businessconditions. In January 2006 alone, forexample, Citigroup and Motorola announcedthat they would move away from quarterlyearnings guidance, and Intel, asserting that“updates were
increasingly irrelevant
tomanaging the company’s long-term growth,”announced that it would end its midquarterupdates on sales and profit margins.But many companies that currently offerguidance are reluctant to stop: in our survey,executives at 83 percent of them said thatthey had no plans to change their programs.These executives indicated that they fear thepotential for increased share price volatilityupon the release of earnings data, as wellas the possibility of a decrease in shareprices, if guidance were discontinued. Theexecutives also worry that discontinuingguidance will make their companies lessvisible to investors and analysts.But when we analyzed 126 companiesthat discontinued guidance, we found thatthey were nearly as likely to see higheras lower
TRS
, compared with the market.Of the 126, 58 had a higher
TRS
in theyear they stopped issuing guidance, and68 had a lower TRS compared with the
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The misguided practice of earnings guidance
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