What is an Earnings Guidance?
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.
Let us first understand why are earnings announcement important?
Every company is required to report quarterly results as well as annual results at the end of the year. In India the financial year concludes in March and therefore we see a spate of annual results coming in the months of April and May. These earnings announcements are statutory requirements as it is part of the listing agreement with the stock exchanges.
The quarterly announcement puts out the sales, operating profit and net profit figures for the last quarter. Normally, numbers are compared on a YOY basis i.e. the results of the quarter are compared with the corresponding quarter in the previous year.
This captures the cycles of the business better. Earnings announcements are the starting point for analysts to revise their earnings estimates of the company upward or downward. It is also a key document for lenders to judge the financial health of the company and for equity investors to be reassured of the performance of the company. Let us now move on to earnings guidance.
Why Some Companies Stopped Giving Guidance
Claiming that guidance promotes the market’s focus on the short term, some companies stopped providing guidance in order to try to combat this obsession. However, eliminating guidance will not change the market’s fixation on the short term because the market’s incentive policies cannot be dictated.
Everyone on Wall Street is paid annually and gets paid more if they outperform in that year. This focus will not change if companies don’t talk to the Street.
The Good: More Information Is Always Better
Earnings guidance serves an important role in the investment decision-making process. Under current regulations, it is the only legal way a company can communicate its expectations to the market. This perspective is important because management knows its business better than anyone else and has more information on which to base its expectations than any number of analysts.
Consequently, the most efficient way to communicate management’s information to the market is via guidance. In an ideal world, analysts who choose to listen to these numbers would use this information in combination with their own research to develop earnings forecasts.