By Joel F. Houston, Baruch Lev, and Jennifer Tucker
arnings guidance – managers’ public forecasts of forthcoming earnings – is a widespread, yet highly controversial practice. A recent position paper by the CFA Institute and the Business Roundtable emphatically recommended that corporate leaders “end the practice of providing quarterly earnings guidance.” Purists argue that managers should leave securities valuation and the underlying forecasts of future performance to investors and analysts. Lawyers warn that earnings guidance increases litigation exposure. Regulators and commentators fret that previously issued forecasts motivate managers to meet forecasts even when doing so requires them to cut advertising or research, or, worse, to manage earnings. Others object that quarterly guidance leads managers to cater unduly to the demands of short-term investors. All in all, concludes McKinsey & Co., “earnings guidance is misguided.”But managers often claim that guidance is necessary to keep analysts’ earnings forecasts within a reasonable range to avoid large earnings surprises that increase stock price volatility. Some observers note that successful earnings guidance enhances investor confidence in managers’ ability. And economic theory teaches that credible and relevant information disclosures, such as high-quality earnings guidance, decrease information asymmetry and improve resource allocation in the capital markets.
Who is right? We believe that the answer relies less on opinion and more on data. We set out to investigate the countervailing claims about guidance by looking at the financial and economic consequences of guidance. To do so, we constructed a series of tests that compared the performance of companies that stopped issuing guidance after having done so, with the performance of those that continued to offer guidance. The intriguing results suggest that reducing disclosure by stopping guidance benefits neither investors nor companies.
Stoppers and Maintainers
Using the First Call Company Issued Guidelines (CIG) and Factiva news databases, we compiled a sample of 222 firms that stopped giving guidance between the first quarter of 2002 and the first quarter of 2005, along with a sample of 676 guidance maintainers. “Guidance stoppers” were firms that issued guidance for at least three out of the four pre-event quarters, but gave no guidance for any of the four post-event quarters. Those that provided guidance for at least three out of the four quarters in both the pre- and post-event periods were termed “guidance maintainers.”
"Economic theory teaches that credible and relevant information
disclosures, such as high-quality earnings guidance, decrease information asymmetry and improve resource allocation in the capital markets."
First we examined the financial reasons for stopping guidance. Compared with the guidance maintainers, we found that guidance stoppers in each quarter before they stopped guidance reported losses and earnings declines (compared with the year-before quarter) more frequently, while guidance maintainers met or beat consensus forecasts more frequently. Compared with the overall population of US firms, guidance stoppers performed worse in each of these three areas while guidance maintainers performed better. More important, we found that as the stoppers approached the event quarter, they increasingly suffered losses, earnings declines, and a failure to meet or beat analyst consensus. This pattern was reversed for the maintainers.
Several other metrics pointed to greater instability and poor performance among stoppers. During the pre-event (stopping) period, relative to maintainers, the stoppers more often experienced a change of CEO/CFO, had higher earnings uncertainty, higher incidences of losses, larger decreases (or smaller increases) in earnings, and poorer records of meeting/beating either analyst consensus or their own earnings estimates. The stoppers meet or beat analyst expectations only 69.2 percent of the time, while the maintainers’ did so 83.3 percent of the time. Reflecting their relatively poor performance, the stoppers posted lower market-adjusted stock returns in the pre-event period than did the maintainers. A similar dynamic could be seen after guidance was halted. Relative to the maintainers, the stoppers suffered from significant decreases in analyst coverage, significant increases in analysts’ forecast dispersion and forecast error, and experienced no changes in capital expenditures and R&D spending.
Guidance detractors often argue that guidance isn’t necessary because managers aren’t any better at predicting earnings than analysts and investors. To test this claim, we studied the usefulness of quarterly guidance in two ways. First, we tested the extent of analyst revisions of earnings forecasts following the issuance of company guidance. Collecting the last forecast issued by an individual analyst before and immediately after the release of company guidance allowed us to chart the direction of analyst forecast revisions following guidance. (To avoid confounding news, we excluded guidance issued concurrently with quarterly earnings announcement events.) We found that for both negative and positive guidance, over 50 percent of analyst revisions were made within two days of the guidance and that 96 to 98 percent of these revisions were in the direction of the guidance. This remarkable correspondence between guidance and analyst revisions attests to the usefulness of company guidance. Second, we gauged the accuracy of guidance by comparing company guidance with the subsequent reported earnings, and with the most recent analyst forecast issued before the guidance. In 70 percent of the cases, company guidance was more accurate than analysts’ forecasts.
Given these findings, it’s something of a mystery why firms would stop offering guidance. Most firms did not announce or explain changes in their guidance policies. Among those that did, frequent reasons for stopping were the redirection of investors’ attention from quarterly earnings to the long-term goals of the company, managers’ difficulties in predicting earnings, and following peer firms’ guiding practices. When the National Investor Relations Institute (NIRI) asked members contemplating discontinuing guidance to list the reasons why they were considering doing so, the top three were a change in management philosophy (47 percent), industry trend (27 percent), and low earnings visibility (25 percent).
"Critics may think that guidance has a pernicious influence on the public capital markets – one that harms investors, doesn't help analysts, and pushes managers into self-defeating, myopic actions. The data tell us otherwise."
There clearly is something to what the respondents said. For example, a change in management philosophy regarding guidance most likely occurs with a change in the top management. When we ran the numbers, we found that firms are more likely to cease guidance if they have recently undergone or plan a change in their senior management. And when we looked at the proportion of companies in the firm’s two-digit SIC code that did not provide any quarterly guidance in the pre-event period, the data showed that a firm is more likely to stop guidance if a larger proportion of its industry peers did not provide guidance. Furthermore, we expect that a new management team is more willing than an existing team to steer the firm’s guidance policy away from popular practices in its industry. We also found that past and anticipated difficulty of forecasting earnings contributed to guidance cessation.
Beyond these stated reasons, however, there may be an unstated yet important motive for stopping guidance: poor performance. The existing academic body of evidence on voluntary disclosure strongly indicates an increasing tendency to disclose in good times and, by implication, a decreasing tendency to disclose when performance deteriorates. And we found strong and consistent evidence that poor performance – both realized and anticipated – contributed to firms’ decision to stop guidance. In our tests, the probability of stopping guidance was significantly and negatively associated with past earnings performance and with anticipated future poor performance. Meanwhile, firms with a higher litigation risk were more likely to cease guidance, suggesting that firms with high litigation exposure limit their public disclosures.
Much of the debate about guidance revolves around its effect on the information environment surrounding firms. We addressed these arguments empirically in several ways. For example, we examined the effects of guidance cessation on analyst coverage. Analyst coverage makes a firm better known to investors and the decreased information asymmetry helps generate investors’ interest to hold the stock. It is not surprising that 95 percent of the respondents to the NIRI survey believe that one of the benefits of providing guidance is to improve the communication between the firm and its analysts/investors. When we compared the average number of analysts following a company during the pre-event period with that in the post-event period, we found that guidance cessation was associated with a significant decrease in analyst following.
Investors’ reactions to earnings announcements are another gauge of the change in the information environment. Other things being equal, the richer a firm’s information environment before an earnings announcement, the weaker the investors’ reaction to reported earnings should be. So we examined whether the guidance stoppers’ earnings-returns relation was different in the post-event period than in the pre-event period. The data indicated that investors responded more strongly to earnings announcements after firms stop guidance, which is evidence of a relatively poor information environment post guidance cessation.
Guidance stoppers and their supporters frequently claim that after guidance cessation, firms provide substitute disclosures about strategy and long-term objectives to mitigate investor myopia. We examine this assertion empirically by collecting and coding stoppers’ forward-looking disclosures in quarterly earnings press releases and in the Management, Discussion & Analysis (MD&A) section of the quarterly reports. We randomly chose 100 stoppers from our stopper sample, and, for each stopper, we randomly chose a fiscal quarter in the post-event period, which we referred to as the “post-quarter.” We looked at forward-looking, non-earnings disclosures in nine categories and compared the number of disclosures in the pre- vs. post-quarter. The data show that more stoppers decreased forward-looking disclosures than those that increased disclosures: 41 decreased, 29 had no change, and 27 increased. We also found that stoppers curtailed their annual guidance.
Finally, we looked into a major argument of guidance detractors: quarterly guidance focuses managers’ attention and decisions on the short-term at the expense of long-term growth. Regulators and trade associations have similarly expressed concerns that quarterly earnings guidance has contributed to managers’ myopia. If quarterly guidance indeed increases managers’ myopia at the expense of the firm’s long-run growth, we should observe an increase in long-term investments, such as capital expenditures and research and development (R&D), once firms stop quarterly guidance and managers are unshackled by the myopic earnings game. To test this assertion, we measured long-term investments by both capital expenditures and R&D intensities – i.e., deflating the expenditures by the beginning-of-quarter total assets. Because a firm’s long-term investments are likely to vary across industries, we adjusted capital expenditures and R&D in each quarter by the median levels of these investments in a firm’s industry. We found that guidance stoppers do not increase their long-term investments after the guidance cessation. This finding, however, may not be generalized to the population of firms not providing guidance. Recall that guidance stoppers are characterized by relatively poor earnings performance in the pre-guidance cessation period and anticipate continuation of poor performance after stopping guidance. Accordingly, the long-term investment opportunities and decisions of these firms may be different from those of the general population of non-guiders.
Next, we considered the flipside of this issue and examined the stoppers that subsequently resumed providing guidance. Among our 222 guidance stoppers, a full 68 firms (30.6 percent) resumed quarterly guidance, according to either the CIG database or our news search in Factiva. The median length of the silent period was six quarters – a relatively short time for a reversal of a significant change in disclosure policy. To analyze the determinants of guidance resumption, we used a sample of 42 firms as our resumer sample. We found that relative to the non-resumers, the resumers experienced (weakly) a larger decrease in analyst following, a smaller increase in forecast dispersion, a decreasing percentage of loss quarters, and improved earnings in the silent period. Thus, firms that resumed quarterly guidance were by and large affected more severely by the stopping decision.
The debate on guidance is clearly continuing. In June, a coalition of labor unions and CEOs, led by the Aspen Institute, issued a plea for companies to cease giving quarterly guidance. But our investigations show that the concerns surrounding guidance aren’t necessarily borne out by activity in the marketplace. Critics may think that guidance has a pernicious influence on the public capital markets – one that harms investors, doesn’t help analysts, and pushes managers into self-defeating, myopic actions. The data tell us otherwise.
Joel F. Houston is Bank of America Professor at the University of Florida's Warrington College of Business Adminstration, Baruch Lev is Philip Bardes Professor of Accounting and Finance at NYU Stern, and Jennifer Tucker is Luciano Prida Sr. Term Professor at the Fisher School of Accounting, University of Florida.