John M Green suggests boards rethink whether volunteering of earnings guidance is worth the effort and the stress.
“Prediction is very difficult, especially if it’s about the future,” said soccer player and Nobel Prize-winning physicist, Niels Bohr.
Crystal balls are always cloudier than we think, especially for any complex business in this volatile world.
So why do so many companies keep giving earnings guidance, especially when it can create unhelpful market noise, feed short-termism and encourage destructive management behaviour?
Several directors recently told me their boards issued guidance because “the Australian Securities Exchange (ASX) rules or the Corporations Act require it.”
But they are wrong. Neither a law nor a rule, it is simply a market practice, though a firmly rooted one.
ASX neither encourages nor discourages guidance, though in guidance note 8, it emphasises that a company will need to make a disclosure if its reported earnings are likely to materially differ from market expectations.
Despite there being no general duty, some directors believe that the market will reward a company for voluntarily issuing guidance, for example, with an enhanced share price.
But does guidance truly have a positive effect? Investor Warren Buffett and global management firm McKinsey & Company argue it does not.
Buffett said many years ago that it is “both deceptive and dangerous for CEOs to predict growth rates for their companies. They are, of course, frequently egged on to do so by both analysts and their own investor relations departments. They should resist, however, because too often these predictions lead to trouble. Lofty predictions [don’t just] spread unwarranted optimism. Even more troublesome is they corrode CEO behavior [with] CEOs engaged in uneconomic operating manoeuvres [to] meet earnings targets.”
McKinsey has released three pieces of research over the last few years that suggest likewise but go further, perhaps counter-intuitively finding that even if your company provides earnings per share guidance, it will not be valued higher than companies who do not bother. Secondly, earnings guidance might well reduce volatility but that does not drive valuation levels; and finally, companies spend too much time managing their earnings against their shorter-term guidance without seeing any share price benefit.
McKinsey’s analysis was performed on US quarterly-reports, whereas Australia’s norm is half-yearly but, surely, if predicting three months ahead is a waste of time, predicting over longer periods will hardly be less problematic.
So, as your board steps into 2015, with guidance being both voluntary and of dubious value, it might wish to pause and consider whether continuing to issue guidance is worth the effort, the stress and the possible management corrosion – and that is before you remember the pack of class action lawyers circling outside your boardroom door.
That said, if you’ve already been dispensing the guidance drug to the market, suddenly turning off the supply tap may lead to market withdrawal symptoms, and almost inevitably to sharp criticism of your management and board.
Pause for thought
So if you are thinking of stopping guidance, do it after careful thought and planning, and perhaps consultation with your key investors, to ensure you will have your eyes open.
However, none of this is intended to discourage companies from talking to the market about their future.
First, although there is no obligation to volunteer earnings guidance (except when a material over or undershooting of market expectations is likely), companies are obliged to discuss in their annual report their longer-term “business strategies, and prospects for future financial years” (section 299A of the Corporations Act). The Integrated Reporting movement would like even more.
But even without a legal imperative, investors could be justified in expecting to be told about such matters, and companies could also benefit from doing so. Articulating a company’s longer-term issues and its general strategies to exploit or mitigate them should, for example, help attract a greater weight of the kind of investors you want.
That sounds great, but when directors remind themselves about the inadequate legal defences they will have if, despite their best efforts, they get forward-looking statements “wrong”, they will tend to limit their canvassing of the future to the bare legal minimum. A proposal to fix this is currently before the federal government: the Australian Institute of Company Directors’ proposed Honest and Reasonable Director Defence. Like Niels Bohr, it is impossible to predict if, let alone how, the government will deal with this impediment to richer disclosure.
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