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. ...