Most good management teams know intuitively that providing guidance, an estimate of a company’s future earnings, is a disclosure practice that can lead to better valuation. To withhold guidance is to be, or at least appear to be, unhelpful to Wall Street. Worse, the absence of guidance may lead analysts and investors to conclude that a company’s business is volatile and that it is not easy for management to forecast future performance.
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That said, the market turmoil of the past three years has forced many companies to operate with a reduced level of visibility and confidence. As a result, some have chosen to reduce the granularity or frequency of guidance while other have ended the practice altogether.
The shift away from traditional guidance practices was understandable at first. Wall Street knew that most companies needed to adjust their planning and, in some cases, the fundamentals of their business model for the “new normal” environment. However, over the past year or two, companies have become more comfortable with their ability to plan and forecast their business in a difficult market environment. Consequently, guidance practices have made a significant comeback with some companies even returning to a detail-oriented approach.
For companies still holding back on providing guidance, consider the following hypothetical scenario that illustrates the impact guidance can have regardless of a company’s actual performance:
There are two relatively fast-growing companies in the same industry – ABC Corp. and XYZ Inc. Last year, they each earned $0.75 in earnings per share and finished up strong, but the pace of growth is slowing a little as they go forward.
At the beginning of the new fiscal year, ABC’s management says it can grow to produce earnings in the range of $0.95 to $1.00 per share on about 15% revenue growth. XYZ’s management doesn’t give guidance, and its analysts assume the company will continue a 20% sales growth rate and forecast a consensus of $1.10 per share.
Over the course of the year, both companies end up growing revenues at 15% and earning $1.05 per share. ABC makes or beats its earnings projections every quarter by a couple of pennies and hits the sales expectation. At some point mid-year, ABC’s management raises its guidance to a range of $1.00 to $1.05 and confirms that revenue growth is on track with expectations.
ABC Corp’s analysts and shareholders are happy and feel like they have a good handle on the business. They feel like ABC’s management knows how to run the company well.
XYZ’s performance is identical, but the company misses analysts’ expectations every quarter by about the same amount as ABC’s outperformance.
One analyst decides that XYZ can’t meet the consensus expectations and, while he doesn’t change his estimates, he lowers his rating to “neutral” and comments that the company is consistently missing expectations.
XYZ’s management, while very positive because the business is growing nicely, unfortunately has little choice but to dodge some direct questions on a conference call about its outlook, creating further anxiety among investors who believe management is evasive.
The financial performance of ABC Corp. and XYZ Inc. is exactly the same… but, which stock do you think gets a higher price and which management team do you think ends up with the better reputation?
Providing guidance does not, in and of itself, change the results of a business, but it does alter an investor’s perception of those results. And from an analyst’s perspective, if management can’t forecast, then it is very difficult to have confidence in your own projections.
James Palczynski is the Senior Managing Director at ICR Inc and joined ICR in 2000 after seven years as a sell-side analyst. After serving for four years on a top-ranked Institutional Investor team at Salomon Smith Barney, James served as senior vice president and analyst for Ladenburg Thalmann and Needham & Co. His investment banking experience includes lead-managed IPO's, secondary offerings, private financings, and advisory services on M&A activity.