Most larger public companies provide some form of earnings guidance to the investment community. Without guidance, analysts and investors have no idea how a company will perform in the future, and so must make their own estimates of the situation. These estimates may vary considerably from each other. The result is a heightened amount of stock price volatility, since everyone is assuming a different future earnings level
Stock price volatility is not a desirable state of affairs for a company. It tends to attract short sellers, who make money from rapid changes in the stock price. It also drives away institutional investors, who prefer stocks whose prices move within a narrow range. Since institutional investors are driven away, there is less demand for a company’s stock, and its price will decline. This results in a higher cost of capital for the company, since it must issue more shares in order to obtain a specific amount of cash. Thus, there are serious consequences to not providing guidance.
Also, a company may have no analyst following, which is the norm for micro-cap entities. If so, there is no one who can independently provide earnings predictions to the buy side, which leaves the marketplace completely devoid of information if a company refuses to provide guidance. This situation is most likely to result in excessive stock price volatility. Thus, in order to avoid volatility, the absence of analysts makes it even more necessary to provide guidance.
Though the issues noted above are compelling, there is a situation where it still makes sense to avoid issuing guidance – specifically, when management does not have a clear picture of future results. This is most likely to occur when a company is generating a large part of its operating results from a series of acquisitions, is experiencing large swings in its material costs, or is entering new markets. In all of these cases, operating results may vary so significantly that it would be doing a disservice to the investment marketplace to issue guidance that could rapidly be proved erroneous. Under this scenario, it is better to state the situation, and promise that guidance will be provided at some point in the future, once results become more predictable.
It is also possible that a company’s forecasting systems are so inadequate that it is routinely exceeding or falling short of its guidance by significant amounts. In this case, the investment community will assume that the management team is incapable of forecasting its own business. If so, it may be better to forego guidance until the company can install better forecasting systems that result in predictable guidance.
The most common type of guidance issued is for either a range or specific point, and usually includes all key factors that would be of interest to an investor, such as revenue, margins, net income, and earnings per share. The range of expected results issued should be relatively narrow for the near future, and expand as projections go further into the future, thereby allowing for greater uncertainty. An example follows:
We are raising our guidance for the fiscal year ended December 31, 2008. We now expect 2008 sales to range between $120 and $135 million, resulting in net profits of between $14 and $17 million, and diluted earnings per share ranging from $1.43 to $1.49. For the year 2009, we are expecting sales to range between $130 and $160 million, resulting in net profits of between $16 and $21 million, and diluted earnings per share ranging from $1.48 to $1.60.
An alternative is to provide guidance using percentages. By doing so, analysts can construct their own models of a company’s performance, and plug in the latest guidance to arrive at their own conclusions about the company’s likely performance. This type of guidance should include some sensitivity analysis, where the guidance states how a given percentage change in revenue will impact the gross margin and net profit. Some companies even itemize the business assumptions underlying their models. An example follows:
Our projected revenue growth is 7-10 percent. Based on our estimated increase of five percent in cost of goods sold, we are projecting gross margins in the range of 50 percent to 55 percent, with the low end of the range based on seven percent revenue growth and the high end based on 10 percent revenue growth.
If a company is not willing to provide this level of guidance, then a lesser alternative is to discuss anywhere from a one to five-year projection, the long-term strategy, or the business cycle within which the company operates, and how that cycle impacts its results. These alternative choices are deemed insufficient by analysts, since such broad categorizations of results are of little use to them when trying to construct an earnings forecast. An example follows:
We expect continued revenue growth of 60-80% for the next three years, as we continue a rapid expansion through our franchising model. Due to expansion costs, we expect net profits and earnings per share to grow during that period at a reduced rate of 15-25%.
An alternative to the various types of formal guidance shown above is to release a broad range of non-material information to analysts. They can then use this information to create their own models of a company’s operations and likely operating results. This is called the “mosaic” approach, because they must assemble disparate information into a composite picture of the company. This is a useful approach for a company, because it can avoid any specific guidance, but is painful for analysts, who must work much harder to create their earnings models.
Once the decision is made to release a certain type of information to the marketplace, be prepared to continue issuing it on a long-term basis. Otherwise, the market can react quite negatively when information is discontinued, on the suspicion that the company is hiding information that no longer casts it in the best light.
Under no circumstances should a company issue aggressive guidance, where the targeted results will be extremely difficult for a company to achieve. This may result in a short-term ramp up in the stock price, but will inevitably yield a price crash when the company eventually cannot achieve its own guidance. If a company persists in repeatedly issuing aggressive guidance that it cannot sustain, then the result will be persistent price gyrations, unusually high price volatility, and the arrival of short sellers.
A much better alternative is to always provide guidance that is solidly within the management team’s comfort zone. If everyone in a company knows they can attain the guidance levels, then they will be less fixated on reaching the target, which reduces the risk of fraudulent reporting. Also, by providing reasonably conservative guidance, analysts will find a company to be more trustworthy and reliable, and will be more likely to provide coverage.
Given the range of options regarding the format, frequency, and timing of guidance, it makes sense to formalize a company’s preferred approach with a guidance policy. The policy should state the general type of information to be released, when guidance shall be provided, and whether current guidance will be updated when existing guidance is obsolete. Finally, the policy should require the inclusion of meaningful cautionary statements to avoid liability for issuing guidance. A sample policy follows:
The company will provide guidance to the investment community, which shall encompass information regarding revenue, gross margins, net income, and earnings per share. Also, the company may selectively provide guidance regarding new products and markets.
The company will endeavor to update guidance when, in management’s opinion, the current guidance has become materially misleading. At a minimum, new guidance shall be issued on a quarterly basis, immediately after the release of the 10-Q report.
All guidance must be clearly identified as forward-looking statements, and be accompanied by meaningful cautionary statements that actual results could differ materially from the guidance.
In summary, guidance should be used whenever corporate results can be forecasted with some degree of accuracy. The main area in which guidance tends to become a problem is when it is too aggressive. Instead, a company should adopt a long-term policy of providing slightly conservative guidance, which the company can reliably attain. In addition, guidance should consistently include the same types of information over a long period of time. By doing so, there is less risk of stock price fluctuation and fraudulent financial reporting.