Quarter quake: Earnings reports are still vital for investors to be able to analyse a company
Investment guru Warren Buffett often pops up in the news calling for companies to stop providing quarterly earnings guidance because it promotes short-term profits over long-term sustainability.
And when the pandemic hit the Berkshire Hathaway chairman got his wish, with hundreds of firms suspending their guidance as projections were made worthless by the uncertainty wrought by COVID-19.
Indeed research from consulting giant McKinsey showed that companies who provided no guidance didn’t generate any lower returns to shareholders compared with those that did.
The Big Three consultancy’s research also suggested that if companies issue short-term quarterly earnings guidance there is an increased likelihood of inefficient use of managers’ time, including real earnings manipulation – which can erode long-term performance.
In addition, McKinsey reckons such guidance may attract investors with a short-term focus, which could increase share price volatility. These concerns mean some firms have not brought the practice back after the pandemic.
But my research with Beatriz García-Osma and Encarna Guillamón-Saorín, of Universidad Carlos III de Madrid, has found that quarterly earnings forecasts may actually help with planning and information flow, and so in fact create a better environment for long-term performance.
If it is done regularly and for the right reasons, then quarterly forecasting should be encouraged by regulators, and can be a useful tool in communicating with the wider market - aligning market expectations with those of the company.
There may be other lessons for management too, in looking at why they are producing the forecasts, and what this may say about wider governance issues within the company.
I was inspired to do this research by my experience working at media conglomerate Thomson Reuters. I used to receive a lot of phone calls with many analysts and bankers interested in guidance information to help improve their own analysis and forecasts.
The process seemed to improve the flow of information and so narrow the difference between data available to investors and to those inside the company. It didn’t seem to always be the case that companies were providing unrealistic numbers and having to chase them.
The real distinguishing factor appeared to be the motivation behind reporting the numbers – those issued to inform the market were less likely to involve real earnings manipulation than those released for strategic reasons.
Looking at the existing research, I saw that it treated all earnings forecasts as equal, and did not attempt to identify the reasons why they were issued.
So, we attempted to categorise quarterly earnings forecasts into those done to inform the market and those done for strategic reasons.
A strategic motivation seeks to avoid negative earnings surprises or beat analysts’ consensus earnings expectations. This could involve issuing quarterly earnings guidance above or below the consensus and then manipulating earnings in an opportunistic way.
An informative guidance, on the other hand, is issued primarily to align market expectations with the company’s own.
Managers have more information than the market – so can help analysts make more accurate forecasts. So, when a forecast is issued to inform the market, the market moves closer to the real situation, reducing the incentive to manipulate earnings.
The difficult part is to identify which forecasts are strategic and which are informative.
How to spot quarterly earnings issued to manipulate the market
Existing research only looked at earnings manipulation done through accrual-based management, where ‘creative’ accounting - although within regulations and standards - can adjust earnings numbers to some extent by adding more future revenue under accruals, which is money that is due but has not yet been paid.
Short-termism is more likely related with real earnings manipulation that requires more fundamental actions within the company, such as cutting prices or R&D expenditures to boost earnings, which may help boost quarterly cash flow but could also affect overall long-term profitability - leading to a lower company value.
This cannot be captured by looking at the manipulation of the accruals number in the accounts, which doesn’t have a direct affect on future cash flows.
To correctly identify evidence of short-termism, we used a measure of real earnings manipulation that considered R&D expenditures, pricing strategy and other factors that could boost quarterly earnings, but could also hit a firm’s future value.
The research also identified typical characteristics of strategic and informative forecasts. If the forecasts are issued infrequently, including to promote good news, or in situations of high earnings pressure, then they tend to be more strategic.
After all, any history of strategic manipulation would quickly become apparent to analysts if there was a regular reporting track record.
It is difficult to be a strategic forecaster unless the reporting is infrequent and there is no regular history to evaluate. However, while informative forecasts do seek to align market and company expectations, if they are too accurate, then that is also a signal the firm could be behaving in an opportunistic way.
So, while there has been much discussion over banning short-term forecasting, regulators instead should perhaps be looking at the motivations for the reporting of this information.
If companies are keen to report, then they should be encouraged to do so on a regular basis. The practice should only be discouraged if done irregularly by opportunistic firms acting strategically.
Companies too, should seek to produce informative, accurate and regular quarterly forecasts to ensure an optimal relationship with the wider markets.
If regular quarterly forecasts disappeared, the market would lose an important source of information that helps analysts evaluate a company’s prospects.
This could be damaging to companies, particularly when raising capital, as there is evidence that releasing information on a voluntary basis decreases the cost of capital.
Another lesson is that it is not the forecasts themselves that creates short-termism within a company. This is already present for some other reason, normally related to governance or misaligned management incentives, so if forecasts are found to be strategic then this should also be reviewed by analysts and maybe regulators.
There may be some bad eggs out there producing misleading quarterly guidance, which may stick in the mind of long-serving analysts like Buffett.
But the evidence suggests most are providing useful information - data that can also be used to spot badly run companies.
García Osma, B., Guillamón Saorín, E. and Mercado, F. 2023. Quarterly earnings guidance and real earnings management. Journal of Business Finance & Accounting, 50, 5-6, 1029-1059.
Facundo Mercado is Assistant Professor of Accounting and teaches Corporate Reporting and Decision Making on the Global Online MBA and Global Online MBA (London). He also lectures on Financial Statement Analysis and Security Valuation on the Undergraduate programme.
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