Here then are reasons a company should consider giving guidance to investors:

1. You are a small cap company and have low sell side analyst coverage. One of the big issues for small cap stocks is simply getting on the radar screen of analysts and getting coverage. Anything a company can do to improve their chance of coverage (read: make life easier for the analyst), including issuing guidance, should come into play in order to gain the increased trading volumes, liquidity and visibility that come with increased sell side coverage.
2. You are in a predictable business with good insight into near term revenues and profits. Companies with recurring revenue streams or large backlogs of orders to be fulfilled in the near future are an example here.
3. You are in a predictable industry that is not prone to large swings due to economic factors or trends where virtually everyone else issues guidance and you would stand out like a sore thumb if you did not also give guidance.
4. You don’t want to give continuous updates on your business in between quarters. The more transparent you can be on a continuing basis, the less you need to help the street by giving guidance.
5. Management has the intestinal fortitude to run the business to plan and not manage the earning to hit guidance. Accounting is full of subjective judgments and timing issues. It is possible to move revenues into the current quarter or fiddle with loss reserves to make earnings look better in the quarter so you hit your guidance. This is almost never a good thing, but the pressure to “hit the numbers” can be overwhelming at times. Don’t issue guidance if it is going to warp the way you run your business.
6. You recognize that occasionally you will be wrong with your guidance and are willing to make the necessary corrective announcements.
7. You figure that the market is going to make a forecast anyway, so why not take control of the process.

On the other hand a company is not a good candidate to issue guidance under the following circumstances:

1. Don’t give guidance if you are in an unpredictable business. This should be obvious, but you see it all the time. For example, property and casualty insurance companies are in the business of underwriting uncertain risks. They don’t know when the next natural disaster will wreak havoc with their earnings, so it makes no sense for them to be giving guidance on earnings.
2. Don’t give guidance if you are not very good at it. If your company has given guidance in the past, but you find that you have to constantly revise the numbers downward, or you are wrong more than you are right, guidance is more trouble than it’s worth. Find a better solution.
3. Don’t give guidance if it will cause management to engage is short-term practices that are not in the best long-term interests of the company. Jiggling things around to “hit the numbers” is a slippery slope at best and the road to perdition at worst.

In my next post I will talk a bit about alternatives to guidance a company can give.
 

 Guidance, Part 2 – Thinking Through the Process

It is a practice fraught with difficulties, not least of which is that companies often get it wrong. The business of forecasting is, by its very nature, an uncertain one, and the opportunities to go astray are numerous.

However, because the market is focused on future cash flows as a means of valuing a company, investors will make an estimate of upcoming earnings whether the company helps them or not. And if they don’t help in some fashion, the dispersion of estimates will be wider than if investors had received some input from the company. Companies don’t like widely dispersed estimates and therefore often wind up issuing guidance. But the input companies give to lower estimate dispersion doesn’t have to be guidance.

Guidance is merely the result of a series of inputs and estimates the company has made. Rather than give the market the estimated answer, companies can just as easily give investors the estimates for some of the inputs to the equation. If the company supplies its estimated ranges for the major components of the income statement; revenues, expenses and anticipated changes to the tax rate, investors will be able to draw their own conclusions as to earnings.

Alternatively, a company can increase the amount of interim information it makes available as a way of avoiding guidance. Many companies tend to be “black boxes” in between reporting periods.  This is unfortunate, because the ideal of a good corporate disclosure program should be to dispense enough information, and update the information frequently enough, so that investors are able to reasonably reach informed decisions about how you are performing. For example, many retailers put out monthly sales numbers. By the time quarterly earnings come around, everyone knows the sales number for the quarter. For many companies, this eliminates guessing around one of the more uncertain numbers on the quarterly income statement and reduces the need for guidance.

If company management really means it when they say they are running the company for the long-term, then consider telling the market what your long-term goals are, and how you’ve performed against them. An example here might be, “We expect that on a three year rolling average our sales growth will be between 8% – 10%. With sales at this level, we believe that we should be able to lower our expense ratio by about 1% – 1.5% per year. This should give our earnings growth a trend line in the high single digit to low double-digit range. This may not occur every year, but we expect things to average out in that range.”

Finally, at the far end of the spectrum, consider reporting unaudited earnings more frequently. Progressive Insurance, an American automobile insurer, reports its income statement and balance sheet monthly. Since it began doing so, its stock volatility has declined noticeably, as it has eliminated uncertainty by increasing information flow.

 Giving Guidance – Alternatives

Based on personal experience, the perception among corporate executives is that analysts spend their time in front of their computers doing research and constructing earnings models, interspersed with an occasional phone call and the odd trip to visit company management. Yet this is well off the mark, and its implications can have a serious effect on a company’s approach to investor relations.

I’m not aware of any academic research considering the relations between sell side analysts and corporate investor relations departments, so I am going to confine myself to a few simple calculations in order to make my points.

The first thing to consider is the number 50%. That is the percentage of time sell side analysts tell me they spend on marketing to the buy side, the investment shops that actually buy, sell and hold securities. So if your average workaholic sell side analyst is putting in 60 hours a week at their job, that means at most 50% of their time, or 30 hours, can be devoted to research on companies they follow. Consider next that the average sell side analyst covers between 10 – 15 companies. If we give the sell side the benefit of the doubt and say they cover 10 companies, that means on an average week they have 3 hours to devote to any single company. And that does not allow for any work the analyst may do on industry wide analysis and deals the investment banking department may want input on. What this means for investor relations is that sell side analysts are very time stressed.

Many companies take the position that the job of an analyst is to analyze and the company should not have to spoon feed them information about the company and the industry. In an ideal world this would be true, but the reality is that the easier you make it for the analyst to get good information, the more likely their analysis is to be accurate. This is because they often don’t have time to go out and get good information on their own.  If on average an analyst has three hours a week to produce quarterly notes, chase down buy side requests for information and talk to company management, it doesn’t leave a lot of time for incisive research and writing.

From an investor relations policy standpoint, this means that companies should think about establishing baseline disclosures, beyond what is mandated by regulation, that can help analysts understand the company and the trends it faces. By getting the basics out of the way, this will allow time strapped analysts to focus on what’s important and they have a better chance of getting it right. It’s one of those rare instances where by helping someone else out, you can also help yourself.

 Using Simple Math to Inform Your Disclosure Policy

To recap, where you are in terms of your corporate life cycle is a large determinant in whether you get Growth, Growth at a Reasonable Price (GARP), Value or Deep Value investors. As each of these different styles of investors is willing to pay differing amounts for your future earnings, the valuation you get in the stock market will in no small degree be influenced by where investors view you in your life cycle. To carry this one step further, we will now use the graph to look at how companies seek to avoid the point at which they transition into a mature, and then a declining company and how successful this is in avoiding a declining P/E ratio.

In product development, when a product threatens to become mature, the marketing people move in and try to rejuvenate and refresh the brand by introducing new product features and formulations or market applications. The idea is to boost sales volume and market penetration. Nobody wants to get to the point where a product is mature, verging on stale, and headed for inevitable decline. In graphical terms, what they do looks like this:

Companies do the same thing.  A great example of a company continually reinventing itself via new products and markets is Apple. First Apple was a computer company. Then they introduced the iPod and iTunes. This was followed by the iPhone, Apps and the iPad. Apple has been incredibly successful in this approach—helped by great design and engineering—creating a tightly integrated suite of products that customers love.  And the stock market has richly rewarded them for this, making Apple one of the most valuable companies on the planet.

In addition to new products, companies attempt to prolong their progress up the growth curve through acquisitions, entering new markets, entering new territories, going global, reengineering their work processes, expense initiatives and a raft of other things too numerous to mention. In doing this they hope to extend their growth and the premium investors will pay for their future earnings.  The problem with all of this, from an investor’s viewpoint, is that the new products, programs and initiatives are exactly that, new, and they don’t have a track record. Therefore, the certainty with which future earnings from these programs can be predicted is less than it is for existing operations and the willingness of investors to pay up for the incremental earnings is less.  Unless and until a company can establish a track record for successful entry into new products or markets or initiatives, investors will discount the future earnings at a greater rate than the old familiar type of earnings. Investors just don’t like uncertainty. So revenues may go up; earnings may in fact also go up, but P/Es will fall until a company can demonstrate that it has as one of its core competencies the ability to extend its growth with new initiatives. There is a zone of uncertainty that surrounds the new initiative until things resolve themselves, which graphically looks like this:

Again, if we look at Apple, the first iPod was introduced on October 23, 2001.  Following the announcement of the new product, one that turned out to be revolutionary, Apple’s stock price didn’t do much for the next couple of years. Investors had a wait and see attitude.

This, of course, drives corporate management nuts. They have invested millions of dollars in a new initiative through design and engineering, consulting fees and countless meetings and studies. They are embarking on a bold new strategy to push their company forward for the next millennium. And yet, in their view, the market doesn’t get it. Usually, if you get them off in a quiet room with a scotch or two in them, they will blame this on “Typical Wall Street short-sightedness”.  Yet in this case, investors are really taking a longer term view as they want future uncertainties to be resolved before buying the stock.

Investor relations professionals should learn to recognize this type of fact pattern and be ready to explain to management why the stock didn’t jump when the CEO’s latest initiative was announced. Much heartburn can be avoided if companies take a realistic approach to how the market values new corporate actions. There is no real way around this – companies have to prove themselves to investors on new initiatives to a far greater extent than for existing operations. But as witnessed by Apple, it can be done.

 More on Marketing, Corporate Life Cycles and Investor Relations

In short, if financial theory holds that that the value of a firm is equal to the sum of its future cash flows, discounted back to a present value, then one of the jobs of investor relations is to provide enough forward-looking information to investors to allow them to make reasonable estimates of future performance.

Most investors, in making these estimates of future value, will construct financial models because you can’t just pick a number out of the thin air. Over the years I have seen a number of variations on how models get constructed, using earnings per share, EBIT, EBITDA, NOPAT and free cash flow to name a few. They are usually constructed using a five-year horizon but some optimistic modelers use a ten-year horizon. However, no matter how they are constructed, they operate in the same general manner, taking values in time, computing a final terminal value, and discounting the values and terminal value back to a present value, using a discount rate. As a result, some general observations can be made that can help investor relations practitioners keep the big picture in mind.

First, because most models rely upon year-over-year compounding, consistently improving earnings will be valued more highly than inconsistent earnings. Mathematically speaking, if a company’s earnings fall from 100 to 50 in a year, they have declined by 50%. However, in order for earnings to get back to 100 in the following year, they must go from 50 to 100, a 100% increase. When plugged into models that rely upon year-over-year compounding, erratic earnings in the form of years that show a decline in earnings result in much lower valuations than companies that consistently grow year-over-year. This is something that most investor relations officers understand intuitively, but it’s always nice to know there is an underpinning financial theory to it.

Secondly, also as a result of the way compounding and discounting work, investors will value consistent earnings more than the promise of big profits in the later years. This is the ‘Bird in hand’ theory. So-called ‘hockey stick’ projections, where earnings are flat for several years until the big payoff come in the later years, are less valued for two basic reasons:

• first, discounting – the farther out into the future you push future profits, the more they get discounted. Additionally, the farther out in the future they are projected to occur, the more uncertain they become and investors assign a higher discount rate to them. Higher discount rates result in lower present values
• second, compounding – the earlier one receives profits, the more compounding will occur, resulting in a higher present value.

The final effect of compounding and discounting to consider from the way financial models work is that a projected change in the earnings estimates has a greater effect in the earlier years than it does in the later years. Thus if an analyst trims estimated earnings for next year it has a greater effect on the estimated fair value of the stock than it does if the estimated earnings for year five are lowered.

Not all earnings projections are created equal and those closer to the present carry a greater weight.

 More on Financial Theory, Future Estimates and Investor Relations