Investor Relations: Guidance (#63)
/In this podcast episode, we discuss the need for issuing earnings guidance to the investment community, including tips regarding the nature of that guidance. Key points made are noted below.
The Need for Guidance
Without guidance, investors have no idea how a company will perform in the future, and so they have to make their own guesses. Since no one is basing their guesses on any real information, you’re going to see a broad range of estimates. And that translates into a great deal of stock price volatility, because everyone assumes that the company’s stock should be at a different price point.
Now, stock price volatility is not good. First, it attracts short sellers, who make money from rapid changes in the stock price. It also drives away institutional investors, who prefer stocks whose prices move within a narrow range. Since institutional investors are driven away, there’s less demand for a company’s stock, and so its price declines. This results in a higher cost of capital for the company, because it has to issue more shares in order to raise money. So, there’re some major consequences to not providing guidance.
Also, let’s say that a company has no analyst following, which is normal for smaller public companies. If so, there is no one who can independently provide earnings predictions, which leaves the marketplace completely devoid of information. So, the absence of any analyst following makes it even more useful to provide guidance.
When Not to Issue Guidance
But there is one case where it still makes sense to avoid issuing guidance – That’s when management doesn’t have a clear picture of future results. This is most likely when a company is buying a lot of companies, or it’s entering new markets. If so, its results may vary so much that it really isn’t helping to issue guidance that’s quite possibly wrong. Under this scenario, it’s better to state the situation, and promise to provide guidance at some point in the future, once results become more predictable.
It’s also possible that a company’s forecasting systems are so crappy that it’s routinely issuing poor guidance. In this case, the investment community will assume that the management team doesn’t know what it’s doing. If so, it’s better to stop issuing guidance until it has better forecasting systems.
So, let’s say that you consider those issues, and decide to provide guidance – which is usually a good decision. If so, the next question is – what kind of guidance.
The Type of Guidance to Issue
The usual type of guidance is for a range of possible results, and includes all the major factors that would be of interest to an investor, such as revenue, gross margins, net income, and earnings per share. The range of projected results should be fairly broad the further into the future you go, since that’s the most uncertain. Short-term results should fall within a tight range.
Here’s an example. We’re raising our guidance for the fiscal year ended December 31. We now expect the year’s sales to range between $120 and $135 million, resulting in net profits of between $14 and $17 million, and diluted earnings per share of between $1.43 and $1.49. For the following year, we’re expecting sales in the range of $130 to $160 million, resulting in net profits of between $16 and $21 million, and diluted earnings per share of between $1.48 and $1.60.
An alternative is to provide guidance using percentages. By doing so, an analyst can construct his own models of a company’s performance, and plug in the latest guidance to arrive at his own conclusions about the company’s likely performance. For example:
Our projected revenue growth is 7-10 percent. Based on our estimated increase of five percent in the cost of goods sold, we’re projecting gross margins in the range of 50 percent to 55 percent, with the low end of the range based on seven percent revenue growth and the high end based on 10 percent revenue growth.
If a company isn’t willing to provide this level of guidance, then a lesser alternative is to discuss the general financial situation, or the long-term strategy. For example, you could say:
Our long-term strategy is to expand our franchising model throughout the North American region, with a target store opening rate of 150 per year.
A different method is to release a broad range of non-material information. Analysts then use it to create their own models of a company’s operations and its likely operating results.
This is called the “mosaic” approach, because they have to piece together lots of information into a composite picture of the company. It’s for a company, because it avoids any specific guidance, but it’s a royal pain for an analyst, who has to work much harder to create an earnings model.
Now, once you decide to release information to the marketplace, be prepared to continue issuing it for a long time. Otherwise, the market can react quite negatively when information is discontinued, since they assume that the company is hiding information. So, if you think that information that was included in guidance is now irrelevant, then be sure to explain the reason for the discontinuance in some detail. Otherwise, you might be looking at a decline in your stock price.
When to Update Guidance
If you give guidance, then update it on a regular schedule. This usually means issuing quarterly guidance, right after the quarterly 10-Q report is released. Analysts depend on quarterly guidance, so they can revise their own estimates of company performance. If a company elects to forego quarterly guidance in favor of some longer period, it’s possible that some analysts will find it too difficult to provide estimates regarding company performance, and they’ll drop their coverage. If this happens, stock price volatility may increase, because there’s uncertainty about how the company is doing. So, provide frequent guidance updates to avoid excessive movement in the stock price.
There are some cases where it’s reasonable to issue guidance even more frequently than on a quarterly basis. For example, if a company has an analyst following and a number of them are projecting really high or low results, consider giving immediate guidance to put them back on track. By doing so, analysts can alter their projections at once, thereby keeping the company’s stock price from tracking in accordance with those incorrect estimates.
Also, if a company doesn’t revise its guidance, then the investment community assumes that the information in the last guidance is still current. So, if circumstances have changed, and made the current guidance misleading, then issue new guidance in advance of the normal guidance release schedule. But only do this if the level of change is very substantial.
Whether to Issue Aggressive Guidance
Under no circumstances should you ever issue aggressive guidance, where it’ll be difficult for the company to achieve the forecast. What happens then is a short-term ramp up in the stock price, followed by a price crash when the company can’t achieve its own guidance. If a company repeatedly issues aggressive guidance, then you end up with very high price volatility, which drives away long-term investors.
A much better alternative is to always provide guidance that’s within the management team’s comfort zone. If everyone in a company knows they can attain the guidance levels, then they’ll be less fixated on reaching the target, which reduces the risk of fraudulent reporting. Also, by providing reasonably conservative guidance, analysts will find a company to be more trustworthy and reliable, and so they’ll be more likely to provide coverage.
But, this doesn’t mean that you should always issue excessively low guidance. If a company routinely exceeds its guidance by a large margin, then analysts will expect the same thing in the future. So, if a company were to only meet its own guidance, analysts might treat this as poor performance. Therefore, the best level of guidance is to issue slightly conservative numbers.
In short, use guidance whenever you can forecast results with some reasonable degree of accuracy. Where guidance causes problems is when it’s too aggressive, so be consistently just a bit conservative.