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Within Reach: The Incentive to Meet Earnings Estimates


4/15/2011

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Click for PDF of original storyWoe to the company that fails to meet its earnings estimate. The price of its stock will almost certainly fall, stockholders will grumble, and managers could be on their way out.

The comparison of analysts’ earnings estimates to actual earnings is one of the most closely watched rituals in the financial world. To miss an estimate by as little as a penny a share invites trouble.

Many corporate managers deal with this quarterly ritual with a ritual of their own. They try to steer analysts toward a number the corporation can meet or beat. Sometimes they do this by providing management’s own earnings estimates; sometimes they do it by providing a few key tidbits of useful financial information.

Once the analysts have reached a consensus estimate, management can then make minor but legal accounting adjustments to ensure they meet or beat that number. For instance, they can boost profits by changing their estimates of how long equipment will last. This would reduce the allowance for depreciation.

KevinJackson

As a result, a missed earnings estimate is often construed as a sign of trouble. “If they miss, then they didn’t even have the margin to manage earnings,” says Kevin Jackson, assistant professor of accountancy. “The impact of that can be pretty dramatic, and it would be reflected in stock prices.”

Focusing on Strategy

The quarterly task of meeting or beating analysts’ estimates is time consuming, and it can detract from a company’s ability to manage for both the short and long term. “Managers have been surveyed as to whether they had decided not to make a capital investment because the expenditure would make them miss an earnings forecast,” says Jackson. “A majority said they had done so at some point.”

BrookeElliott

W. Brooke Elliott, associate professor of accountancy, says management’s fixation on earnings estimates leads to short-term thinking. “Numerous studies have documented that managers often behave myopically—focusing on managing quarterly earnings to meet expectations in lieu of
focusing on the long-term strategy and fundamentals of the firm. Over time, this behavior can lead to a reduction in the long-term value delivered to shareholders.”

Occasionally, companies decide they won’t play the game, because it distracts executives from running the company.

But that tactic can backfire. “Google initially adopted a policy of providing no earnings guidance,” says Elliott. “In the fourth quarter of 2006, Google missed analysts’ expectations for the first time, and the stock plummeted 17 percent.”

That tie to stock price certainly is an incentive for companies to get their earnings number right. However, there’s no guarantee that meeting or exceeding estimates will ensure higher stock prices. In fact, companies that beat their estimates on a regular basis may find that their solid performance becomes expected and actually makes it harder to impress investors.

But as a rule, companies play the game and meet the estimates.

Making Your Move

While there are downsides to this process, there are benefits as well. Earnings estimates give fund managers and the investing public a hard number to help them decide whether to buy a company’s stock. The same number is used by capital markets in determining not only access to capital, but its cost. The number can also be used along with other data in mergers and acquisitions.

Analysts typically provide much more than just an earnings estimate, for those who care to read it. They may reveal that particularly good or particularly bad results are an anomaly. They can warn of trouble down the road. And they can provide a wealth of data about a company that the investing public doesn’t have time to gather on its own.

Jackson provides this example: “Let’s say that you have a company whose earnings go up, but the details suggest that a good profit this quarter may not be sustainable. A fixation on estimates and whether the company meets or beats them can blind investors to the long-term outlook. Or if you have a company that boosted profits by reducing research and development expenditures, it’s a sign that the future is not very bright.”

TimJohnson

Says Tim Johnson, associate professor of finance, “There are definite benefits to having an analyst follow a company. We want analysts to aggregate information that would be very costly for us to collect.”

Analysts are part numbers cruncher, part gumshoe. They may unearth information about a company’s shipments, new contracts, or legal problems, for example. “Professional analysts are very busy people,” Johnson says.

Although analysts provide a wealth of information, the investing public tends to fixate on the earnings estimate and the comparison of that estimate to reported results. This fixation ends up causing problems. But a recent study by Elliott, Jackson, and Jessen Hobson, assistant professor of accountancy, suggests management could diffuse the problem by putting earnings into perspective. “Our idea was to reduce the fixation on net income as the one important number,” Hobson says.

Management could do this when it issues earnings guidance, by breaking the company’s financial results into components such as gross revenues, cost of sales, depreciation, and research and development. “This would remind investors that earnings are just one piece of the puzzle, not the whole puzzle,” says Jackson.

For example, a company could boost its earnings and meet their earnings forecasts by slashing R&D expenses. In that case, investors who fixate on earnings might assume that a company had performed well because their earnings results met their guidance, when in fact it had mortgaged its future. With disaggregated earnings guidance, investors could more readily identify the change in R&D expenses and more accurately determine whether the final number is good or bad news, Jackson says.

In the long run, breaking out the numbers would benefit the company as well. Says Elliott, “If investors aren’t fixated on quarterly earnings, then management’s myopic behavior may be curtailed. Managers can still provide the necessary information to capital markets but, at the same time, can reduce the focus on earnings as the primary indicator of firm performance.”

Getting it Right

The earnings estimates the public sees are the tip of a much larger analytical machine. Buyout firms, for example, employ in-house analysts to determine the finances of potential buyout targets. An example would be Warren Buffet’s Berkshire Hathaway. Berkshire may spend billions of dollars on an acquisition, and it wants to make sure the outlay is justified and that it isn’t paying too much. So it supplements information from other sources with information it collects itself. “Companies like Berkshire Hathaway do most of their analysis in house,” says Johnson.
“They have their own people out there sniffing around.”

GNarayanamoorthy

Earnings estimates are also used for firms that aren’t publicly traded, says Gans Narayanamoorthy, assistant professor of accounting. These can be used to determine a buyout offer. “Let’s say you want to know what to pay for an ice cream shop that’s not publicly traded. In that case, you might hire a consultant or an auditor to go over the books and say, ‘This is what the revenues and earnings are.’ Then you could use those numbers to figure out what the shop is worth.”

For the most part, the earnings-estimate process is on the up and up. “It’s possible for a company to make small changes to conform with analysts’ estimates,” says Narayanamoorthy. “If it looks like they’re going to be a penny short, they may make small but subtle changes. But if the gap is large, they probably won’t try to boost earnings because it could trigger shareholder litigation accusing them of cooking their books.” Narayanamoorthy’s research found that management would instead be likely to issue earnings guidance to get analysts to revise their estimates lower, so shareholders wouldn’t be blindsided by bad news.

And at least for the moment, Congress has given executives an added incentive to play it straight. “The Sarbanes-Oxley Act requires executives to certify that their accounting is accurate,” says Narayanamoorthy. “Of course, there will always be the Enrons of this world, where they make changes in their accounting to show that they are much better than they actually are. But that is a rare occurrence.”

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