Earnings guidance is alive and well.

Author:King, Tom
Position:FROM WHERE I SIT - Column

Earnings guidance--the sharing of a corporation's internal projections with outsiders--was a hot topic a decade ago when blue chip firms like The Coca Cola Co., McDonald's Corp. and The Gillette Co. announced that they would no longer provide earnings per share (EPS) projections to investors. Critics argued that guidance can bring short-term decision-making or accounting shenanigans.

Some observers predicted that Coke's action presaged an end of this form of disclosure. Yet, a review of reporting practices of S&P 500 firms in mid-October 2012 shows that earnings guidance remains alive and well.

Many investors evaluate a firm's performance by comparing reported earnings with expectations as measured by the consensus (average) EPS estimate from sell-side analysts covering a firm. Brokerage houses hire sell-side analysts to offer research and advice to client investors. These analysts become experts in a given industry and publish research reports that typically include company-specific investment recommendations plus EPS forecasts for future accounting periods.

Analysts' estimates emerge in the absence of any guidance from management. For example, on the morning of May 18, 2012, before Facebook Inc. began trading as a public company, financial websites displayed consensus EPS estimates even though the firm had yet to field a single investor relations telephone call. Analysts update estimates as new information becomes available.

Differences between consensus estimates and actual earnings can lead to unwanted stock price volatility. If a company's consensus figure is too high, reported income will miss the estimate, leading to a likely sell-off in the company's stock. If the consensus figure is too low, reported income will beat consensus, but this financial success may cause investors to ratchet expectations to unrealistic levels and give rise to a future earnings miss. Managers prefer to avoid both surprises.

Some firms choose to bring analyst expectations closer to internal earnings projections by offering earnings guidance for one or more future accounting periods. Projections can be a point estimate (e.g., "management expects the firm to earn about $1 per share"), a range ("between $0.90 and $1.10") or a boundary ("at least $0.90") for a future quarter or year. Guidance includes affirming a previously given projection or warning that the firm's earnings will not meet expectations for the current accounting period.

Guidance offers...

To continue reading