Tuesday, March 13, 2007

For The Long Term

Should guidance be eliminated? Guidance, for those who are unfamiliar with the term, is the practice of publicly traded companies forecasting their earnings, typically for the next quarter and fiscal year. It has been an issue for years, because many people believe that guidance influences companies to run their businesses for the short-term rather than the long-term.

Guidance has its advocates … and its detractors.

Pros
Companies that employ guidance and meet or surpass their targets send a message to Wall Street that they truly know what makes their businesses tick. They can correctly predict their business, thereby, gaining the confidence of security analysts that follow the company and who develop their own forecasts. Guidance accuracy reflects well on the company’s management because their comments can be depended upon. Guidance is good for the stock price and the market in general, which is based on perceptions and particularly perceptions about a company’s performance in the future. Investors buy stock based on what they believe will happen. Guidance forces companies who are not going to meet target to “come out” long before the quarter numbers are in and advise investors. Overall, guidance builds stock market momentum and enables investors to fairly value a company’s shares by reducing information gaps.

Cons
On the other hand, guidance encourages companies to focus on short-term rather than long-term results. Many make an enormous effort to meet or exceed the projected target because of the stock market consequences if they don’t. Some take actions they might otherwise not take, such as delaying the purchase of new technologies or other capital expenditures when, in fact, such actions may be counterproductive in the long-term. Companies worry – and for just reason – that if they miss their targets, analysts will downgrade their stock, causing the share price to decline by reflecting to investors that the company doesn’t know it’s own business as well as it should. Many observers believe that companies that formerly provided guidance and then decided to stop are sending negative signals about future performance.

An article titled, “Reporting for Duty,” by Robert C. Pozen, (NYT 3/3/07), provides data that offers mounting evidence that suggests that giving quarterly guidance is detrimental to a company’s long-term performance. Key among the data in the story was a survey by the National Bureau of Economics Research of 401 senior firm executives that 80 percent were willing to forego spending on research and development (an expense that would diminish profits) to meet their quarterly targets, and 55 percent were willing to delay projects that promise gains in the long-term for their company. Logically, another study showed that those who use the technique are less likely to achieve long-term earnings growth anyway. And a CFA Institute study showed that 76 percent of analysts themselves supported the end of guidance. Significantly, a McKinsey Study noted that when a company abandoned the guidance practice, trading value did initially drop, but the difference disappeared within a year.

All of the above argues for a permanent end to guidance, and Pozen notes that the US Chamber of Commerce Commission on the Regulation of Capital Markets in the 21st Century, of which he is a member, will urge an end to giving quarterly guidance in favor of companies taking a long-term approach and providing more information to investors’ long-term plans.

The article says, “we must help chief executives free themselves from the tyranny of…meeting their own public predictions” even though analysts may continue to predict quarterly, causing CEOs to still feel some pressure. For that, CEOs should meet with analysts quarterly to correct any mistaken assumptions made. Nevertheless, I am certain there are companies that are “exceptions to the rule.”

All of this makes good sense to me, because it will, I hope, help companies invest dollars in valid enterprises that bring future success, rather than on potentially short-term, ineffectual — and ultimately costly — cosmetic actions.



Technorati Tags: guidance, quarterly guidance, stock market, investors, Robert C. Pozen, National Bureau of Economics Research, 2006 McKinsey Study, US Chamber of Commerce Commission on the Regulation of Capital Markets in the 21st Century, business, communications, public relations

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