Straight up

Professor Paul Kerin explains why it is vital to be clear, honest and concise when communicating company information to the market.

External communication of company information is one of the hardest things to get right. Boards and CEOs face difficult trade-offs in deciding what information is disclosed, how and when. Companies are required to make various disclosures, such as issuing regular earnings reports and immediately disclosing “material” information. However, beyond that, companies have substantial discretion. The key goal in communicating with capital markets is to better inform equity and debt investors and build trust, thereby improving share valuations and credit risk assessments. Fortunately, we can glean five tips from economists’ research on how to do it.

1. More is better than less.
With one exception, the market reaction to voluntary disclosures is positive (on average).

2. “Soft” information matters.
While markets react to “hard” information, they also react strongly to “soft” information conveyed by the language that accompanies it. For example, markets infer signals about future company performance from the text that accompanies backward-looking numbers in profit announcements. Indeed, a cottage industry had developed to analyse the signalling power of soft information. Analysts count “positive” and “negative” words in announcements to measure management’s “sentiment” (degree of optimism) and words inferring relative confidence to measure management’s degree of certainty.

The evidence shows that unexpectedly positive sentiment generates more positive share price reactions, while more certain language reduces dispersion of both analysts’ forecasts and bid-ask spreads. Forward-looking communications, such as strategy announcements or profit forecasts, contain less hard information than backward-looking communications do.

Therefore, the market places even greater weight on soft information in these communications. If soft and hard information are consistent, market price reactions are stronger; if inconsistent, the market questions company credibility.

3. Don’t exaggerate.
Tip number two does not mean that companies can talk up share prices with rosy language. Indeed, the market discounts “language inflation”. Oral communications (such as investor conference calls and presentations) call for particular care, as company representatives emit more complex and less controlled soft information signals in these interactive communications than those contained in one-way written communications. Body language and demeanour matter. Consistency of language is essential: if company representatives express particularly positive sentiment in introductory remarks, but become less positive under questioning, the perceived attempt at “language inflation” is punished.

4. Reputation matters.
Communication is a repeated game. Overly-positive sentiment and/or overly certain language have future reputation costs. Analysts remember.

The stronger a company’s/individual’s reputation for past accurate communications, the more the market reacts to new soft information. Reputations are also built by treating positive and negative information consistently. Like bad hard news, companies tend to delay conveying negative sentiment. Markets react much more severely to negative sentiment when it is delayed (not expressed until after bad hard information is communicated).

5. Tailor communications
So far, we’ve focused on how to communicate with capital market participants. But what to communicate – and what not to – is critically important too. Disclosures to capital market participants become available to participants in product markets (competitors, customers, suppliers) and the market for corporate control (potential acquirers or acquisition targets). Therefore, disclosures can often have “proprietary costs”: other players might use those disclosures to your shareholders’ detriment. If telling capital markets how you plan to tap highly profitable market segments enables competitor imitation, it becomes self-defeating. Conversely, some disclosures may have “proprietary benefits”; for example, a capacity expansion announcement may deter new entrants.