Time to abolish quarterly earnings estimates

The Securities and Exchange Commission should immediately accept one recommendation of a bipartisan panel established by the U.S. Chamber of Commerce to suggest ways to improve U.S. market competitiveness.
That recommendation is to abolish quarterly earnings guidance by corporate executives to analysts and investors.
Although most of the panel’s recommendations, including some structural changes at the SEC, would require action by the Congress or by the commission itself, the abolition of quarterly earnings guidance by corporations requires no such actions.
Companies simply could announce that they no longer will provide earnings guidance on a quarterly basis. In fact, several companies, including Berkshire Hathaway Inc. in Omaha, Neb., and The Washington Post Co. already have done so.
However, an SEC ban on such guidance, or at least a strong recommendation against it, might be necessary to get all companies to go along. Otherwise, some rapidly growing companies might take advantage of the self-imposed silence of other companies by issuing conservative earnings estimates and then easily beating them, causing their stocks to jump in price.
If all public companies adopted the policy of no quarterly guidance, the result might well be a dramatic improvement in the long-term performance of American corporations and the economy.
Studies have shown that the pressure to provide quarterly guidance to analysts and investors distorts the investment decisions and policies of corporate management teams and imposes a short-term mind-set on them.
Sometimes, that pressure even leads to fraud. Last week, the SEC and the Ontario Securities Commission filed charges against four former Nortel Networks Corp. executives alleging accounting fraud between 2000 and 2004.
According to the civil-fraud charges, the former executives allegedly altered the Brampton, Ontario-based telecommunications company’s financial-reporting practices to meet earnings forecasts and investor expectations.
The charges illustrate the pressure on executives to meet earnings expectations, which they often create through their “earnings guidance” to analysts and investors.
The Nortel allegations, if verified in court, will merely be the latest example to come to light of pressures’ leading to fraud.
There is clear evidence that many management teams are so concerned about producing the level of quarterly earnings that they have led analysts and investors to expect that they often neglect the long-term health of their companies.
One study by two economists at the National Bureau of Economic Research Inc. in Cambridge, Mass., published in June 2004, showed that 55% of corporate managers surveyed said they would avoid initiating a project that promised a highly positive return if it meant missing the current quarter’s consensus earnings estimate — an estimate management often signals.
They also found that 78% of executives would give up economic value in exchange for smooth earnings.
Another study published the same month by the bureau found evidence that executives manipulate earnings in other ways to meet the consensus earnings forecasts.
Of course, when companies fail to meet the earnings estimates by even a few cents, their stock prices fall.
So we have the ridiculous situation of members of corporate management providing quarterly earnings guidance to Wall Street analysts and investors, who then punish the company’s stock when the estimates are missed by a few cents.
The result, as shown by the bureau’s studies, is that investors and corporate management teams act as if the “estimates” are “guarantees,” and some teams then do all in their power to make quarterly earnings meet those estimates, the long term be damned.
More chief executives and chief financial officers should follow the examples of Berkshire Hathaway and Washington Post, and announce they no longer will provide earnings guidance. If they don’t, the SEC should act.
Analysts would then have to make their salaries the old-fashioned way: by earning them. They would have to conduct serious research rather than simply acting as tape recorders that feed back what corporate management teams tell them.
And corporate-management teams could focus on the long-term payoff of investment opportunities rather than the short-term effect on quarterly earnings.
The long-term result is likely to be better management decisions untainted by short-term earnings considerations, healthier corporations over the long term, better investment returns for investors and a stronger economy.