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

Guidance detractors often argue that guidance isn't necessary because managers aren't any better at predicting earnings than analysts and investors. To test this claim, we studied the usefulness of quarterly guidance in two ways. First, we tested the extent of analyst revisions of earnings forecasts following the issuance of company guidance. Collecting the last forecast issued by an individual analyst before and immediately after the release of company guidance allowed us to chart the direction of analyst forecast revisions following guidance. (To avoid confounding news, we excluded guidance issued concurrently with quarterly earnings announcement events.)

We found that for both negative and positive guidance, over 50 percent of analyst revisions were made within two days of the guidance and that 96 to 98 percent of these revisions were in the direction of the guidance. This remarkable correspondence between guidance and analyst revisions attests to the usefulness of company guidance.

Second, we gauged the accuracy of guidance by comparing company guidance with the subsequent reported earnings, and with the most recent analyst forecast issued before the guidance. In 70 percent of the cases, company guidance was more accurate than analysts' forecasts.

Changing Direction

Given these findings, it's something of a mystery why firms would stop offering guidance. Most firms did not announce or explain changes in their guidance policies. Among those that did, frequent reasons for stopping were the redirection of investors' attention from quarterly earnings to the long-term goals of the company, managers' difficulties in predicting earnings, and following peer firms' guiding practices. When the National Investor Relations Institute (NIRI) asked members contemplating discontinuing guidance to list the reasons why they were considering doing so, the top three were a change in management philosophy (47 percent), industry trend (27 percent), and low earnings visibility (25 percent).

There clearly is something to what the respondents said. For example, a change in management philosophy regarding guidance most likely occurs with a change in the top management. When we ran the numbers, we found that firms are more likely to cease guidance if they have recently undergone or plan a change in their senior management. And when we looked at the proportion of companies in the firm's two-digit SIC [Standard Industrial Classification] code that did not provide any quarterly guidance in the pre-event period, the data showed that a firm is more likely to stop guidance if a larger proportion of its industry peers did not provide guidance.

Furthermore, we expect that a new management team is more willing than an existing team to steer the firm's guidance policy away from popular practices in its industry. We also found that past and anticipated difficulty of forecasting earnings contributed to guidance cessation.

Beyond these stated reasons, however, there may be an unstated yet important motive for stopping guidance: poor performance. The existing academic body of evidence on voluntary disclosure strongly indicates an increasing tendency to disclose in good times and, by implication, a decreasing tendency to disclose when performance deteriorates. And we found strong and consistent evidence that poor performance -- both realized and anticipated -- contributed to firms' decision to stop guidance.

In our tests, the probability of stopping guidance was significantly and negatively associated with past earnings performance and with anticipated future poor performance. Meanwhile, firms with a higher litigation risk were more likely to cease guidance, suggesting that firms with high litigation exposure limit their public disclosures.

Much of the debate about guidance revolves around its effect on the information environment surrounding firms. We addressed these arguments empirically in several ways. For example, we examined the effects of guidance cessation on analyst coverage. Analyst coverage makes a firm better known to investors and the decreased information asymmetry helps generate investors' interest to hold the stock. It is not surprising that 95 percent of the respondents to the NIRI survey believe that one of the benefits of providing guidance is to improve the communication between the firm and its analysts/investors. When we compared the average number of analysts following a company during the pre-event period with that in the post-event period, we found that guidance cessation was associated with a significant decrease in analyst following.