Impressed by the precision of a company's earnings forecast? New study urges caution
May 24, 2017
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Perhaps in support of the remark
attributed to Yogi Berra that “it's tough to make predictions especially about
the future,” research has consistently shown precise-sounding forecasts to have
strong impacts, both in bolstering the self-image of those who make them and in
impressing those to whom they are made.
Still, precision would seem hazardous
for corporate executives when forecasts are as keenly scrutinized as those they
make about their firms' future earnings. Citing a prior research estimate that
company leaders meet their earnings forecasts only about six percent of the
time, a new study begins by asking, "Why would top managers issue
very precise judgment, particularly in the crucial domain of earnings forecasts
or guidance of next year's earnings, given that such precise judgment
potentially induces errors and erodes their credibility?"
What the paper in the June issue of
the Academy of Management Journal concludes will
not be encouraging to investors. Management forecasts that are relatively precise,
it finds, generally do not derive from any special insight by the leaders who
issue them and more likely represent an effort at impression management in the
wake of company failures or stumbles.
And, yet, such is the mystique of
precision – or what is referred to in the study’s title as “pseudo-precision” –
that the tactic evidently works.
Based on an analysis of earnings
forecasts issued by a sample of almost 3,000 companies over a period of seven
years (about 90% in the form of predicted ranges), Mathew L. A. Hayward of
Monash University, Australia, and Markus A. Fitza of the Frankfurt School of
Finance and Management, Germany, report the following:
■ After missing the mark in earnings guidance the
previous year, managers narrowed the range of their earnings-per-share
prediction by an average of about three cents, a sharp increase in precision
given that the mean forecast spread for the sample as a whole was about eight
■ After below-industry returns in the quarter prior to
earnings guidance, managers tightened the forecast range by nearly two cents.
■ After a negative market reaction to a recent merger or
acquisition, the forecast range narrowed by an average of about four cents,
half the mean spread for the full sample.
■ Tendencies to court precision were strengthened in cases of
up-guidance – that is, when the level of earnings predicted exceeded levels
What to make of all these findings? "On
the surface, the presented results might seem surprising," the
professors write. "When managers have experienced an organizational
setback, they could be expected to exercise greater care in forecast accuracy.
But resultspresented here are consistent with...evidence of managerial
short-termism, wherein the motivation to be seen as being in control could
trump that of being accurate."
As for why this tendency becomes
stronger in cases of up-guidance, they write that, when managers "forecast
a rosier picture after setbacks… [they] would be even more motivated to
overcome skepticism by using more precise forecasts to strengthen impressions
that they control firm strategy and performance.”
Transparent though these motives may
seem, the study suggests that courting precision yields quite successful market
results. "The efficacy of forecast precision as an organizational
impression management tactic...is quite substantial," the professors
write. "The average [range] of earnings forecasts is eight cents...An
increase from the average precision to the maximum possible precision (a range
of zero) will result in an abnormal return of about half a percent (0.48%).
Given that the average market capitalization in our sample is $1,912,690,000,
this...will increase market value on the announcement day by about $9.18
million...whether or not the guidance represents good or bad news (up or down
In all, Profs. Hayward and Fitza
analyzed data on earnings guidance, stock performance, and diverse operations
of 2,918 companies over a seven-year period. Guidance was defined as the last
annual earnings estimate issued by a firm in its fiscal year, provided it came
at least one month before the fiscal year's end. Measures of companies’
stock performance consisted of cumulative market-adjusted returns from the
beginning of trading on the day before a guidance announcement to the end of
trading on the day after.
In conclusion, the professors observe
that “there is every reason to believe that precision would be used as an
impression tactic well beyond this domain.” As an example, they cite research
showing that “during the global financial crisis of 2008, bank lenders
sought to assure investors that their firms were solvent by making increasingly
precise representations of their capital reserves.”
Further, they continue, “sales people
might use precision to gain authority with, and overcome skepticism
of, new customers. By contrast, they would be predicted to be less precise
in representations to existing and more satisfied customers where
credibility is already established. In the context of new products,
companies would tend to make strong and precise representations about
defect rates or performance because of their managers’ bias towards stronger
impression management. The same mechanisms would be manifested outside the
organizational context including when politicians forecast the costs of
policies or actions and their likely outcomes...In each case, theory here
suggests that the use of precision may have favorable effects on audiences
and stakeholders, but the longer term implications of such judgment
remains an important avenue for scholarly inquiry."
The paper, “Pseudo-Precision? Precise
Forecasts and Impression Management in Managerial Earnings Forecasts" is
in the June issue of the Academy of Management Journal. This
peer-reviewed publication is published six times yearly by the Academy, which,
with about 19,000 members in 128 countries, is the largest organization in the
world devoted to management research and teaching. Its other publications
are Academy of Management Review, Academy of Management Perspectives,
Academy of Management Learning and Education, Academy of Management Annals,
and Academy of Management Discoveries.