Every few months we hear about companies that beat expectations for their quarterly earnings, or fall short, or do something different. Sometimes there are business combinations or spin-offs that confuse the issue. Other times the accounting profession changes the way corporations need to report their financial numbers.
Some CEOs criticize the market’s quarterly earnings derby. They note that quarterly earnings reports are more art than science. Quarterly numbers aren’t even audited – they’re estimates of what’s happened over the past three months. Some firms have done away with providing guidance about what they think the next quarter will bring. Jaime Dimon, CEO of JP Morgan, put it this way: “You don’t know what’s going to happen every quarter. I don’t even care about quarterly earnings.”
He has a point. Quarterly estimates can’t predict one-time events, which by their nature are unexpected. And managers should focus on building the long-term value of the business franchise. But it’s all well and good for Jaime Dimon to stop providing guidance. JP Morgan is one of the largest banks in the world. Analysts need to follow them and provide their own estimates for investors.
But smaller companies don’t enjoy Dimon’s privilege of being 3% of the S&P 500 or one of the Dow Jones 30 Industrials. Most companies need to establish their credibility – their budget discipline, their market growth, and – most importantly – their capital allocation process. To do this, they need to provide earnings guidance and then execute a business plan that meets that guidance. Making and keeping your promises is the best way to build credibility, over time. And having established themselves, it’s hard work to maintain a solid reputation. Investors are right to be skeptical. After all, it’s their money.
Problems arise when making or beating a quarterly earnings estimate becomes the be-all and end-all of corporate management. After all, there’s a rule-of-thumb for analysts that says when a measure becomes a target, it ceases to be a good measure. Sales professionals who understand the new commission scheme will game the system to maximize their income. It’s important that quarterly earnings and revenue performance not be the only measure of success.
But they’re not irrelevant. Short-term performance matters. Some investors don’t have a long-term perspective – elderly individuals with significant embedded gains. And in any case, we have to get through the short-term to get to the long-term. Japan was focusing on long-term projects in the ‘80s. The problem was, they lost discipline over expenses, and when long-term growth prospects collapsed, companies appeared far too bloated.
Quarterly earnings estimates provide accountability for managers and information to investors. A firm that can credibly keep its promises will be rewarded with a higher valuation and a lower cost of capital. At least, that’s how it’s supposed to work.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”