Sucheta Dalal :Projected drawn and quartered
Sucheta Dalal

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Projected, drawn and quartered  

Dec 25, 2006

When Sebi chairman M Damodaran questioned the efficacy of the quarterly earnings guidance last week, he was opening the doors to a raging debate kicked off in July this year. Not all companies in India join the hoopla over providing a guidance and then issuing mid-term corrections or modifications in earnings expectations. Some, like the Tata Group companies, have kept away from the practice even when they operate in sectors where such hype is the highest. On the other hand, the practice has acquired some sanctity because Infosys, the bluest of them all, not only provides an earnings guidance, but its entire top management team is an active participant in the discussions that follow their results announcements. Of course, Infosys also manages to beat expectations and its own projections with unfailing regularity. On the other hand, TCS has steadfastly refused to be drawn into the guidance game.

Going by the international debate on the subject, it would seem that the Sebi chairman will get mixed feedback on guidance, especially about whether it amounts to forward-looking statements. It is well known that investment guru Warren Buffett does not believe in the practice. Companies such as Citigroup, Ford Motors and Google also do not provide earnings guidance, saying that it leads to a short-term focus of management, especially on their share price. CEO salaries are also increasingly based on these earnings numbers and a company’s share price performance.

Interestingly, a whole set of companies have mastered the art of playing the game of tweaking earnings guidance to present themselves in the best light. Analysts recognise this as well, which is why any slip in meeting estimates causes turmoil in the share price. However, there is also a set of companies that is tired of such pressure and short-term focus on earnings alone and is dropping the practice of issuing guidance. Just because a company refuses to provide guidance, analysts will not stop projecting where its earnings and consequently its stock prices are headed. The moot question then is, will the lack of earnings guidance cause more volatility? Earnings guidance by a company forces the analysts’ projections to be range-bound; without guidance there could be a wide divergence of views, fostering increased price volatility. While this is indeed a possibility, an analyst who is wildly off the mark will soon lose credibility and may even attract litigation. 

In July this year, a report by the Business Roundtable’s Institute for Corporate Ethics and the CFA Institute’s Centre for Financial Market Integrity opened the debate on “the corrosive effect of short-term thinking in American business”. It said 76% of the members did not want guidance. The report said, “The obsession with short-term results by investors, asset management firms, and corporate managers collectively leads to the un-intended consequences of destroying long-term value, which decreases market efficiency, reduces investment returns, and impedes efforts to strengthen corporate governance”.

Unscrupulous companies find innumerable ways of making forward-looking statements without providing an official earnings guidance
Yet, a survey by McKinsey Quarterly found that 83% of companies that provide earnings guidance intend to continue doing so. At the same time, it found very little agreement on the costs and benefits or even the consequences of reducing the frequency of providing such guidance. In another article, the McKinsey Quarterly says that many executives believe that providing quarterly earnings guidance helps them maintain an open channel of communication with investors and increase visibility while reducing the volatility of share prices and improving share valuations. The article concludes that the practice offers few benefits and carries its own costs, particularly management time and an overemphasis on short-term performance.

In India, where insider trading rules are fairly new, the more unscrupulous companies find innumerable ways of making forward-looking statements without providing an official earnings guidance. It could well happen that they welcome Damodaran’s view and drop their forecasts. They can then continue with the age-old practice of using media plants to manage their share price and image. In any case, analysts regularly track barely 250 Indian companies.

-- Sucheta Dalal