Corporate Eye

If You Give Guidance, Are You Going in the Right Direction? Part 1

directionToday I want to move from discussing the general aspect of communications in investor relations to one type of communications in particular, that of guidance. 

In a number of ways, companies giving guidance, either on expected revenues or profits, is a mug’s game. If a company gives guidance, and it hits the projected numbers, then they get no credit for it. On the other hand, if the company misses the numbers it guided to, investors really penalize it because they expect the company to have better insight into the business than they do. And if the company is lucky enough to beat guidance, then management was sandbagging the numbers and analysts will raise their future estimates so high that the company is sure to miss expectations in the near future.

Yet the practice is wide spread. According to a 2010 NIRI survey on guidance practices in the United States, of the 269 responding companies, 90% provided some form of guidance, 58% provided guidance on earnings/EPS and 62% on revenue or sales.

Baruch Lev, in his book “Winning Investors Over” uses data from First Call and comes up with around 800 companies that provided quarterly guidance and 1,400 that provided annual guidance in 2007. From this I infer that companies must feel compelled to issue guidance because no sane businessman is going to want to make a public forecast unless he is forced to do so.

And yet there is not a lot of data to either support giving guidance to investors or to remain silent on the issue. And the research that is out there shows mixed results. (I read this stuff and summarize it so that you don’t have to. Believe me, financial academics were not English majors as undergraduates.)

In his book Baruch Lev cites a number of academic studies in support of giving guidance. First, there is a study that shows that companies are more accurate at quarterly guidance than analysts. (This, of course, is not evidence that company guidance is necessarily very accurate, just that it’s more accurate than analysts’.) Second, he cites studies that indicate that guidance enriches the information environment in the capital markets. By this I think he means that the very act of giving guidance is another piece of information, which helps improve transparency. And academic studies show that transparency leads to higher stock prices, lower stock volatility and reduced cost of capital.

On the other hand, the consulting firm McKinsey, in a study published in the Spring of 2006, concludes “Our analysis of the perceived benefits of issuing frequent earnings guidance found no evidence that it affects valuation multiples, improves shareholder returns, or reduces share price volatility. The only significant effect we observed is an increase in trading volumes when companies start issuing guidance…”

So there you have it: duelling experts that lead you to exactly opposite conclusions. Because there is no clear cut theoretical reason for a company to issue guidance, what it boils down to is that each company needs to consider its own situation – the industry they are in, its characteristics, the company’s ability to deliver on its forecasts and a variety of other factors that I will explore in more detail in a following post.

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John Palizza

John recently retired as a Lecturer in Management at Rice University’s Jones Graduate School of Management, where he taught investor relations. Prior to that, John was in charge of investor relations for Sysco Corporation and Walgreen Co. He holds a MBA from the Kellogg Graduate School of Management at Northwestern University and a law degree from Loyola University of Chicago. You can learn more about John’s thinking about investor relations at his blog, Investor Relations Musings.