Earnings guidance is information that a company makes to the investment community regarding expectations for its future earnings. This guidance is issued because of pressure from the investment community for more information about a business, and especially the results it expects to achieve in the near future. An ongoing series of guidance statements could reduce the level of stock price variability, since there is less uncertainty about future results.
Should you formulate guidance on what to expect, or only comply with the basic filing requirements of the SEC? Your decision can have an impact on whether the company will receive coverage from analysts, the variability of the stock price, and even the company’s ability to sell stock.
It is worthwhile to consider the information environment from the perspective of the investor. This person receives information about a business a minimum of four times per year, when the quarterly and annual financial statements are released. These documents are almost entirely oriented toward the historical results of a business, so the investor has little information to use as the basis for future projections. Also, a business may release information at random intervals during the year in the Form 8-K about various material events, such as major agreements entered into or terminated, or the sale or purchase of a business. While this additional information makes note of specific events, it does little to inform the investor about changes in the basic income-generating capabilities of a business.
If analysts are following a company, they will periodically issue estimates of future results. Each analyst has his or her following of investors, so there will be some aggregation of investors around the opinions of their favorite analysts. If there are no analysts following a company, then individual investors must arrive at their own estimates of company performance, which can be wildly divergent from each other. The result is a potentially broad range of estimates regarding what the correct share price should be. Also, as more time passes between the release of the last set of financial statements and the arrival of the next set, there is a greater divergence in views regarding the proper stock price.
The result is a fairly large amount of stock price volatility. This is caused by a continuing series of stock purchases and sales at different price points. Each price point is based on the diverging views of what buyers and sellers believe the stock is worth. Thus, it is reasonable to state that a lack of information about the future prospects of a business increases the volatility of its stock price.
It is useful to provide earnings guidance to narrow the range of expectations for a company’s stock price. This guidance should incorporate the following factors:
Timing. The amount of variability in investor expectations regarding company prospects increases as time passes since the last release of financial information. Thus, a consideration is how frequently guidance should be issued.
Type of information. What types of information does the investment community want to see? The bare minimum is likely to be earnings per share, but you can go further and reveal a broad range of additional financial and operational information.
Guidance range. Stock price variability will be reduced if you issue guidance that stays within a narrow range of possible earnings. This range is driven by the accuracy of the company’s forecasting systems.
Consistency. Investors like to see considerable consistency in the structure and content of guidance over a long period of time.
Guidance is nearly always communicated as part of the quarterly earnings call. This is a conference call in which senior management discusses the results of the most recent reporting period. If guidance is to be given regarding expected future results, it is included at the end of the earnings call.
There are several situations in which guidance may not be appropriate, or where it may even be counterproductive. They are:
Inadequate forecasting. If a company’s forecasting systems are unable to generate reliable guidance that the company can meet, it is best not to issue any guidance until the systems are improved. Otherwise, continually issuing guidance that the company does not attain reflects poorly upon the management team.
New markets. A company may have just entered new markets where it is uncertain of revenue and profit levels, or the ability of the business to grow. If so, any guidance issued has a high probability of being wrong, and so is worthless to investors. In this case, the management team can either issue guidance with very wide estimated ranges, or forego guidance until results become more predictable.
Many acquisitions. The strategy of a company may be to grow through acquisitions. It is difficult to provide guidance under this strategy, since the ability of a company to complete an acquisition has a binary outcome – either an acquisition is completed, or it is not. If guidance assumes the completion of an acquisition, and the deal falls through, then the guidance could be wrong by a substantial amount. This is a particular problem when acquisitions are quite large, and so contribute to a large proportion of a company’s projected financial results.
Development stage company. A small number of companies go public when they are still quite small, and do not yet have a clear idea of the size of their markets, market share, profitability, and so forth. In these cases, it makes sense to resolve the informational uncertainties and then issue guidance.
The situations noted here are in the clear minority for public companies. Usually, a company has been in business for a number of years and reached a certain critical mass before going public, so it should have adequate systems and a sufficient knowledge of its markets and financial results to be able to provide reasonably accurate guidance.