To Guide or Not to Guide: A Look at Earnings Guidance

This research summary was originally published by the New York University Stern School of Business. It was written by Joel F. Houston, Baruch Lev and Jennifer Tucker.

Earnings guidance -- managers' public forecasts of forthcoming earnings -- is a widespread, yet highly controversial practice. A recent position paper by the CFA [Chartered Financial Analyst] Institute and the Business Roundtable emphatically recommended that corporate leaders "end the practice of providing quarterly earnings guidance." Purists argue that managers should leave securities valuation and the underlying forecasts of future performance to investors and analysts. Lawyers warn that earnings guidance increases litigation exposure. Regulators and commentators fret that previously issued forecasts motivate managers to meet forecasts even when doing so requires them to cut advertising or research, or, worse, to manage earnings. Others object that quarterly guidance leads managers to cater unduly to the demands of short-term investors.

All in all, concludes McKinsey & Co., "earnings guidance is misguided." But managers often claim that guidance is necessary to keep analysts' earnings forecasts within a reasonable range to avoid large earnings surprises that increase stock price volatility . Some observers note that successful earnings guidance enhances investor confidence in managers' ability. And economic theory teaches that credible and relevant information disclosures, such as high-quality earnings guidance, decrease information asymmetry and improve resource allocation in the capital markets .

Who is right? We believe that the answer relies less on opinion and more on data. We set out to investigate the countervailing claims about guidance by looking at the financial and economic consequences of guidance. To do so, we constructed a series of tests that compared the performance of companies that stopped issuing guidance after having done so, with the performance of those that continued to offer guidance. The intriguing results suggest that reducing disclosure by stopping guidance benefits neither investors nor companies.

Stoppers and Maintainers

Using the First Call Company Issued Guidelines (CIG) and Factiva news databases, we compiled a sample of 222 firms that stopped giving guidance between the first quarter of 2002 and the first quarter of 2005, along with a sample of 676 guidance maintainers. "Guidance stoppers" were firms that issued guidance for at least three out of the four pre-event quarters, but gave no guidance for any of the four post-event quarters. Those that provided guidance for at least three out of the four quarters in both the pre- and post-event periods were termed "guidance maintainers."

First we examined the financial reasons for stopping guidance. Compared with the guidance maintainers, we found that guidance stoppers in each quarter before they stopped guidance reported losses and earnings declines (compared with the year-before quarter) more frequently, while guidance maintainers met or beat consensus forecasts more frequently. Compared with the overall population of U.S. firms, guidance stoppers performed worse in each of these three areas while guidance maintainers performed better. More important, we found that as the stoppers approached the event quarter, they increasingly suffered losses, earnings declines, and a failure to meet or beat analyst consensus. This pattern was reversed for the maintainers.

Several other metrics pointed to greater instability and poor performance among stoppers. During the pre-event (stopping) period, relative to maintainers, the stoppers more often experienced a change of CEO/CFO, had higher earnings uncertainty, higher incidences of losses, larger decreases (or smaller increases) in earnings, and poorer records of meeting/beating either analyst consensus or their own earnings estimates. The stoppers meet or beat analyst expectations only 69.2 percent of the time, while the maintainers' did so 83.3 percent of the time. Reflecting their relatively poor performance, the stoppers posted lower market-adjusted stock returns in the pre-event period than did the maintainers. A similar dynamic could be seen after guidance was halted. Relative to the maintainers, the stoppers suffered from significant decreases in analyst coverage, significant increases in analysts' forecast dispersion and forecast error, and experienced no changes in capital expenditures and R&D spending.