Earnings guidance has become a key indicator for investors and analysts, but the forecasts S&P 500 companies present to the market are getting less and less accurate.
An S&P Global Market Intelligence analysis found that 16.75% of the index's member companies that issued quarterly EPS guidance in 2018 went on to report results within their guided range. The percentage of companies with results within their guided range has declined on an annual basis every year since at least 2014.
The vast majority of the time, companies beat their guidance, and especially in high-growth sectors like tech and software, doing so has become synonymous with success. In interviews, former CFOs and corporate governance experts described a mix of factors and pressures that drive management teams to undersell their forecasts to curb the repercussions that might come from missing guidance. Companies' habit of setting beatable targets is widely known and expected, analysts said. But critics of the practice say it has enshrined a custom that ultimately only misleads investors.
"Everybody's intentionally gaming the system, and they're doing it so that they can beat the numbers," said James Bianco, president of Bianco Research LLC, a research institution that provides macro investment analysis to institutional investors.
That does not mean the guidance is "useless," but analysts and investors do have to adjust their own expectations in response, he said.
"It's hard for me to believe that investors aren't clamoring for that information if they can get it," said one former director of corporation finance at the SEC who spoke on background. "How much credence they put in it I think probably has to do with what the company's record of performance in hitting the guidance has been."
More high-profile American companies are projecting their future performance than ever before, according to a 2018 S&P Global Market Intelligence analysis of normalized earnings per share guidance for companies in the S&P 500. GAAP guidance issuance has fluctuated year to year with no discernible trend.
The rise in normalized guidance has come alongside calls to halt the practice altogether from some of Wall Street's biggest names. Industry giants like JPMorgan Chase & Co. Chairman and CEO Jamie Dimon, Berkshire Hathaway Inc. Chairman and CEO Warren Buffett, and BlackRock Inc. CEO Larry Fink argue that quarterly guidance puts the focus on the next quarter's results and impedes companies from achieving long-term goals. Companies that provide earnings forecasts likely spend money, time and resources improving their immediate earnings results, critics of the practice say.
But issuers say doing so gives analysts a benchmark for their own models and estimates.
Management teams feel that the market demands guidance, according to Baruch Lev, New York University accounting and finance professor. And once a company starts issuing guidance, stopping would raise suspicion that something has gone wrong.
"In capital markets, as opposed to life in general, no news is bad news," Lev said.
Plus, quarterly results in certain industries — notably, in the technology sector — are harder to predict than others. With more volatile revenue streams and profits, tech companies are more likely to issue guidance than companies in industries such as financials or energy, where there is a long history of predictable trends for analysts' reference.
The degree to which companies miss or exceed their guidance varies between industries, although every industry represented in the S&P 500 sees its companies exceed guidance more often than they miss it.
Technology companies beat their guidance by a median of almost 9% each time, the largest of any industry. Healthcare and industrials are the most accurate industries, beating by medians of just above 2% each time.
Although certain industries might exceed more often and by larger amounts, beating guidance happens across the board. In the 21 quarters included in the S&P Global Market Intelligence analysis, about one-third of the companies that issued GAAP guidance exceeded that projection in more than half of the quarters. The software company Electronic Arts Inc. and the retailer Ross Stores Inc. exceeded in all but two quarters of the analysis.
Beating guidance that consistently should be "next to impossible" to do because of the cyclicality inherent in earnings, said Bianco.
By and large, executives feel the need to shape the narrative around their companies.
"Issuing guidance was expected and required … and there didn't seem to me to be any scope to push back on that," said Ian Leaman, who was the CFO of a U.K.-based company in the oil and gas industry from April 2012 to December 2013. Companies in the U.K. only report earnings every six months and thus typically only issue annual guidance, if any.
Leaman, now a senior financial adviser to private companies, said he also felt pressure to lowball his company's guidance. He called the process of issuing guidance "opaque," with "little clarity" as to how the forecasts evolve. Companies and equity analysts exchange information to improve the analysts' models.
"It's a cat and mouse game" with the analysts, Leaman said. He questioned the value of the process because "it's tainted with this cynical expectation" that the guidance was created to be exceeded.
Another former CFO said the "game" is necessary.
Ken Goldman, who was the CFO at Yahoo! Inc., now known as Altaba Inc., from October 2012 to June 2017, acknowledged the conservatism in issuing guidance but said that without it, analysts' forecasts are too high.
"It's much better to give what the company sees as its expectations going forward than to have analysts try to come up with numbers without having any good sense of the assumptions on expectations," Goldman said.
And if a smaller company does not issue guidance, it risks a high likelihood that analysts will simply not cover it, according to Dan Dolev, an equity analyst at Nomura.
It is almost as important to beat expectations as it is to report strong numbers. The penalty against the CFO specifically for missing guidance is so severe that he or she has an incentive to set a lower range and have a higher probability of exceeding, Leaman said.
Issuing guidance — and determining what numbers to put out — is a collaboration among the CFO, the CEO, planning executives and investor relations, Goldman said. But the CFO leads the process, so missing guidance can be viewed as a reflection of the CFO's judgment.
The market also punishes companies for not hitting guidance. That could spell bad news for C-suite executives, including the CFO, as many companies pay their upper management teams directly with stock or stock options.
That is exactly what happened when one major tech company lowered its guided earnings numbers, underscoring the value in significant changes in the guidance, NYU's Lev said.
"Managers are, to some extent, playing with [earnings]," he said. "But … the message is important, as we saw in the case of Apple."
The tech giant lowered its projected earnings figures Jan. 2, a move promptly followed by a 10% share price drop.
Change the status quo
Companies have free rein to estimate and describe their projections since guidance is not required or prohibited by regulators.
It is difficult for guidance to be a reliable indicator without standards around its issuance, said Amy Borrus, deputy director of the Council of Institutional Investors. Companies can be "sloppy" about what they work into earnings guidance, Borrus said. A beat or a miss "could reflect any number of changes" specific to an individual company or quarter's events, she said. Companies have little guidance on what ought to be disclosed ahead of time or ought to be included in their outlooks.
The SEC has largely taken a hands-off approach to the matter, although it is exploring companies' short-term versus long-term management. In a July meeting, Wall Street's top regulator appeared open to addressing concerns over short-termism. But how exactly it would do so is still unclear.
The current director of the SEC's corporation finance division, Bill Hinman, said it would be difficult for the agency to tell companies not to provide guidance at all, given that it is not a requirement to begin with.
"As exasperating as it can be, I think that guidance is probably here to stay," the former SEC corporation finance director who spoke on background said in a separate interview. The former official does not believe the SEC will regulate guidance or prohibit companies from providing it.
Doing so would be "inconsistent with how they've historically approached forward-looking information," the person said.
And there remains a de facto belief across corporate America that guidance is necessary because competitors provide it and analysts push executives for it, a status quo that Leaman challenges.
"It's just the way things are done," he said.