Three Common Misconceptions About Markets (Or Why Earnings Smoothing, Guidance, And Concern About Meeting Consensus Estimates Are Likely To Be Counter-Productive)

Although many executives strive for stable earnings growth, finance theory and research have long suggested that the most sophisticated investors aren’t especially concerned about “normal” levels of variability in reported earnings. More recent research by the authors and their McKinsey colleagues also suggests that extraordinary efforts to achieve steady growth in earnings per share quarter after quarter aren’t worthwhile and may actually hurt the companies that undertake them. While such efforts to smooth earnings involve real costs, the research finds no meaningful relationship between earnings variability and valuation multiples or shareholder returns.

Based on these findings, as well as considerable experience in advising companies, the authors offer the following advice to senior executives:
• Managers shouldn’t shape their earnings targets or budgets just to meet consensus estimates. Companies that reduce spending on product development, sales and marketing, or other contributors to long-term growth are sacrificing long-term performance for the appearance of short-term strength.
• As the year progresses, managers should likewise avoid costly, shortsighted actions to meet the consensus. Resist the temptation to offer customers end-of-year discounts to boost current-year sales, or to resort to creative accounting with accruals. Investors recognize these for what they are: borrowing from next year’s earnings.

Finally, companies should reconsider the practice of quarterly earnings guidance. Instead of providing frequent earnings guidance, companies should design their investor communication policies to help the market to understand their strategy, the underlying value drivers of their business, and the most important risks associated with the business—in short, to understand the long-term health and value of the enterprise.

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