3 Ways for Companies to Improve Guidance
Over the last few decades, there’s been much debate about what makes for useful management guidance on conference calls and investor presentations.
Here’s Warren Buffett, for example, in his 2000 letter to Berkshire Hathaway shareholders, providing some reasons why guidance is dangerous:
Charlie and I think 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.
It’s fine for a CEO to have his own internal goals and, in our view, it’s even appropriate for the CEO to publicly express some hopes about the future, if these expectations are accompanied by sensible caveats. But for a major corporation to predict that its per-share earnings will grow over the long term at, say, 15% annually is to court trouble. That’s true because a growth rate of that magnitude can only be maintained by a very small percentage of large businesses…
The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced.
On the other hand, Professor Baruch Lev at the NYU Stern School of Business, makes the case that the more information investors have to consider, the better.
More broadly, getting more information out helps everyone involved—shareholders, analysts and companies. By sharing information with the market, companies reduce investor uncertainty and prevent stock prices from swinging wildly upon unexpected bad news. My research shows that managers’ quarterly earnings guidance is more accurate than the current analysts’ consensus forecast in 70% of cases. Analysts know this and are quick to revise their forecasts upon the release of guidance.
But warning investors about potential disappointments doesn’t just help protect them from losses—it helps protects companies, too. Guidance released prior to weak earnings is considered a mitigating factor in shareholder lawsuits, and was shown in a study published in 1997 to reduce settlement figures.
Both arguments have merit, but we believe returning to first principles is critical. If you were making a five-plus year investment in a business, what information would you want to know? Which metrics would you use to hold management accountable?
The long and short of it
We understand that CEOs and CFOs may feel compelled by analysts, traders, or corporate inertia (“We’ve always done it.”) to provide quarterly revenue and EPS guidance.
A 2006 survey by McKinsey, for example, found that executives were reluctant to change guidance practices, as they “fear the potential for increased share price volatility upon the release of earnings data, as well as the possibility of a decrease in share prices…The executives also worry that discontinuing guidance will make their companies less visible to investors and analysts.”
Fair enough, but it’s a problem when guidance becomes a “game” and surpassing revenue or EPS guidance comes at the expense of long-term value creation. If this happens frequently enough, share price volatility will occur anyway. It just gets deferred. Abandoned value-creating projects are fertile ground for competition.
Further, companies that consistently create shareholder value will not be invisible to the market for long, whether or not they issue guidance. Importantly, all stakeholders in a business benefit from long-term value creation: employee stock options are more valuable, shareholders gain from a higher stock price, and creditors and suppliers are more eager to work with you. As Jeff Bezos has noted, “If you’re long-term oriented, customer interest and shareholder interests are aligned.”
Yet we recognize that, as Nobel Prize-winning behavioral economist Daniel Kahneman puts it, “exclusive concern with the long term may be prescriptively sterile, because the long term is not where life is lived.” Setting some shorter-term goals is fine, as long as they are designed to measure progress toward widening the company’s economic moat.
Ensemble’s Wish List for Management Teams
Given the complexity of markets and industries, it’s unfair to recommend a one-size-fits-all solution for improved guidance. Instead, we offer three principles that both investors and companies can use when evaluating guidance practices.
Avoid EPS guidance, if possible. There’s no question that EPS is an important metric to the markets. It is the denominator of the popular price/earnings ratio and is the first metric splashed on financial media headlines. That said, a quarter’s-worth of EPS has almost no bearing on a company’s intrinsic value. Of course, optics are at play here. Growth companies, in particular, can impress the market by frequently beating and raising EPS guidance. Mature firms may need to justify their P/E ratios with steady EPS growth.
We think companies, however, have too many levers to pull to meet or beat EPS guidance. Some levers are more innocuous than others. The market is aware of this flexibility, which makes missing earnings guidance even worse.
Naturally, there are clear incentives for management to hit EPS guidance. Indeed, a 2005 study that surveyed 400 CFOs found that “78% of surveyed executives would give up economic value in exchange for smooth earnings.” When management sacrifices value-creating projects or research & development spending to hit a 90-day target, it comes at the expense of long-term shareholders.
Finally, as long as management is sharing other useful data points (see below), analysts should be able to formulate their own EPS figures.
Instead, companies should share internal operating assumptions. If you invested in a private business, you’d want to know what internal metrics management uses to measure progress. For example, if you were researching a local dry-cleaning business, you’d want to know production output trends, the number of new and repeat customers, customer acquisition costs, and transactions per customer. All of these factors help you understand whether or not the company’s moat is widening or narrowing.
These figures don’t need to be to the basis point or penny, either. Providing a reasonable range for each internal operating metric would be fair and useful.
Some publicly-traded companies do a good job of delivering useful business-level guidance in quarterly reports.
- Schwab’s guidance includes assumptions on market returns, interest rates, and net interest margin. Business updates include metrics on client engagement, competitive dynamics, and expense management.
- Landstar System’s guidance describes incremental margins on a net revenue basis. It provides revenue per load and number of loads hauled each quarter as well as their color commentary on how trends played out during each month of the quarter and how they are playing out so far this quarter.
- International Paper’s quarterly presentations include an outlook on demand trends, margins, catalysts, and free cash flow, as well as commentary on input costs, and its capital investment plans.
Even if management feels it must give revenue or EPS guidance, providing additional operating metrics offers investors more insight into underlying business performance.
Intermediate-term (3-5 year) “targets” should be conservative. Newly-installed CEOs are particularly prone to making ambitious 3-5 year forecasts at analyst days. Perhaps there are qualitative reasons for this – inspiring the team, marking a new era, or building investor confidence – but there’s no better way to erode credibility than to overpromise and underdeliver.
Published intermediate-term targets should be conservatively arrived at, supported with detail, and tempered with a risk discussion. We’re not aware of a company doing a “pre-mortem” (explaining the reasons why they would fall short) on an intermediate-term target, but would consider that a healthy practice.
While management teams often focus medium-term targets on revenue and earnings goals, we think these are less useful than providing targets on working capital needs, line item expenses, capital structure, and capital expenditure plans.
Medium of communication
Some companies, like Expeditors International of Washington and Morningstar, don’t host conference calls. Instead, they welcome questions from all investors (not just sell-side analysts) and respond thoughtfully to the questions in writing. We appreciate the egalitarian nature of this approach. Questions from the broader shareholder base can often be more useful than typical sell-side analyst questions.
We also like that the medium of communication allows management to think about the question and respond with greater detail. A cynic might say this only enables management to artfully dodge questions. Perhaps this is true. However, conference call responses are also usually well-rehearsed.
Of course, we recognize that doing away with conference calls may not be realistic for most companies. And, to be fair, we do find value in hearing management’s tone on conference calls. That said, we would like to see more management teams spend less time on prepared remarks and more time on Q&A with analysts. An excellent example of this practice is Constellation Software.
Management shouldn’t abandon guidance altogether. Rather, we hope more management teams will share information they’d like to receive if they were outside shareholders in the company. Spending less time on the earnings game and more on value creation is in the interest of all stakeholders.
Clients, employees, and/or principals of Ensemble Capital own shares of Charles Schwab Corp (SCHW) and Landstar System (LSTR). The author owns shares of Morningstar (MORN) and Berkshire Hathaway (BRK.B).
While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.
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