Firms, Stock Analysts Should Take A Long View | August 7, 2006 Issue - Vol. 84 Issue 32 | Chemical & Engineering News
Volume 84 Issue 32 | p. 36 | Insights
Issue Date: August 7, 2006

Firms, Stock Analysts Should Take A Long View

Companies should end quarterly earnings guidance and focus on long term, business group says
Department: Business

Each quarter, companies announce their sales and earnings. At the same time, many of these firms estimate what their earnings will be for the coming three-month period−so-called earnings guidance. These announcements can take a number of forms, but usually they are given as a range of earnings per share−for instance, between $1.00 and $1.10 per share. Securities analysts and investors wait with great anticipation for these projections, which give them data on which to base buy or sell decisions.

It wasn't always this way. When I joined C&EN almost 30 years ago, the disclosure regulations were so strict that it was almost, if not totally, impossible for companies to provide these projections. The rules at the time required that a company providing "material" information had to make it available to everyone, not just analysts, and at that time, this meant it had to be disclosed on a widespread basis, usually through large nationwide news outlets such as the Wall Street Journal. Information was considered material if it could affect the stock price.

The result was that companies usually provided business condition information to the analysts, who would use that information to develop their own earnings projections. Granted, there were some flaws in the system. Company representatives were known to call analysts to say, for instance, "I think your projection might be a little low," or "high." But the analysts still had to develop their own forecasts.

Then came the Internet, which provided a means of universal dissemination of information. Companies could disseminate information to all interested parties on a real-time basis. Thus, data could be much more specific, and it could be material because it was available to everyone at the same time. The result was that firms began to provide earnings per share, revenue, and other projections that had not been allowed before.

Many observers think that there is a downside to the current way of doing things. They would like to end the practice of, at least, quarterly earnings guidance by companies, which, they say, makes firms and analysts focus on the short-term rather than the long-term prospects of a company. They would like to see, essentially, a return to the old system.

For years, companies have said they wish that analysts and investors would look at the long term, but many firms continue to provide quarterly earnings forecasts. One chemical company that practices what it preaches is Hercules. Stuart L. Fornoff, the company's director of investor relations, says the company has not provided earnings guidance for a long time, if it ever did. "We want to take the emphasis to the long term," he says.

Last month, the Business Roundtable Institute for Corporate Ethics and the CFA Institute Centre for Financial Market Integrity released the recommendations of a joint forum called Breaking the Short-Term Cycle, in which they called for companies to do the following:

  • End the practice of providing quarterly earnings guidance.

Adopt guidance practices that incorporate a consistent format, range estimates, and appropriate metrics that reflect overall long-term goals and strategy if companies have strategic needs for providing earnings guidance.

Support corporate transitions to higher quality, long-term, fundamental guidance practices, which will allow highly skilled analysts to differentiate themselves and the value they provide for their clients.

The forum notes that, in a recent survey of more than 400 financial executives, 80% indicated they would cut discretionary spending on such areas as research and development, advertising, maintenance, and hiring to meet short-term earnings prospects. The fact that R&D is in this list should give pause to anyone interested in the chemical industry, since R&D is such an important part of a chemical company's future outlook. But history has proven that R&D is always a target because it relates quickly to the bottom line. One need only look at earnings reports during recessions. They show that R&D is one of the first places that companies reduce spending.

A survey conducted by McKinsey & Co. in March 2006 and referenced by the Business Roundtable-CFA forum identified what companies consider to be three significant benefits to earnings guidance: satisfying requests from investors and analysts, maintaining a channel of communication with investors, and intensifying management's effort on achieving financial focus.

Yet, surveys also show that many companies may be ready to move away from short-term guidance. Of 2,749 respondents to a CFA survey of its membership, 76% said companies should move away from quarterly guidance. And of those wanting to move away from the practice, 96% said companies should provide information on the fundamental long-term drivers of the business.

Another survey taken earlier this year, this one by the National Investor Relations Institute (NIRI), showed that 66% of 634 companies responding provide earnings guidance, down from 71% in a March 2005 survey.

However, only 16% of the companies providing quarterly guidance say they are considering taking what might be called an interim step of moving to annual guidance, with 63% saying they are not considering changing and 21% not sure.

While companies say they want analysts to take a long-term view of a firm's outlook, the NIRI survey casts doubt on that and on the companies' confidence in analysts' ability to come up with their own earnings estimates. Just 23% of respondents believe it is likely that a change would result in analysts' taking a long-term view, and only 49% think that, without earnings guidance, analysts would be able to provide reasonable estimates for a company.

Views expressed on this page are those of the author and not necessarily those of ACS.

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