The Dark Side of Earnings Guidance

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Wall Street analysts and the financial media tend to pay a lot of attention to quarterly earnings figures and the guidance provided by companies about those numbers. Although many investors appreciate the visibility provided by guidance, providing it can be a distraction for management and even generate negative incentives when it comes to making decisions with different long and short term implications.

Shares of Caterpillar (NYSE: CAT) took a beating last week when the company reduced its earnings guidance for 2015, from the $15-$20 range to between $12 and $18 per share. Short-term market reactions aside, trying to reach any conclusions from this new information seems like a very complicated endeavor

It’s a considerably wide range: there is a 50% difference between 18$ and $12, so it looks like there are many different possibilities regarding earnings figures for Caterpillar in 2015. Besides, just like the previous guidance was modified, the current one could be changed to the downside or to the upside, and it probably will be modified sooner or later.

I don't blame the company's management for providing such imprecise guidance: Who knows what the global economy will look like between here and 2015? Caterpillar is a cyclical company, and it's exposed to particularly volatile industries like mining and construction, so any serious attempt to forecast earnings needs to leave ample room for error.

The point is that this guidance, necessarily imprecise and subject to modification, doesn't add much value for investors, and it must have taken considerable time and energy from management to produce. In addition, it could really put management in the wrong direction if they take it too seriously.

Caterpillar's management will obviously feel an obligation to deliver those numbers, but they shouldn't really focus too much on specific profit figures. What if there are some interesting opportunities to invest for future growth down the road? This could mean lower earnings, but also more value for shareholders in the long term.

When management gives earnings guidance, they are focusing on the wrong variable – profits for a specific year or quarter – when they should really think about long term value creation. That's why Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) will probably never join the majority of companies which give earnings guidance to investors.

During annual meetings, or in shareholder's letters, Warren Buffett talks about competitive advantages and management quality, and he even evaluates the perspectives for Berkshire's different business lines in the middle term. But I don't think he would ever commit to a specific earnings guidance, that’s just not the kind of things he puts his energy on, and he doesn't believe investors should pay too much attention to it either.

Apple (NASDAQ: AAPL) has found a very particular way to tackle the guidance problem; the company doesn't want to be a slave to Wall Street's thirst for precise figures, but it still gives quarterly estimates. To keep ample flexibility, Apple gives famously conservative predictions, so the company doesn't really need to work very hard or make big concessions in investments in order to meet those figures.

Everybody knows that Apple is very conservative regarding guidance, so analysts usually make estimates which are well above that level. It's like if the company would be telling to Wall Street: “This is the least I expect to report, you figure out the rest of the possibilities.” This is better than committing to a demanding profit target, which could put short term earnings before long term value creation, but still not bold enough for a company like Apple.

I like Google's (NASDAQ: GOOG) approach better. The online search giant doesn't play the guidance game. Google has invested in projects like Android, Chrome and YouTube for years without making any money from them. If management had felt any pressure to meet a particular profit figure these strategic investments could have been affected in a negative way.

It's not like earnings guidance will necessarily derail management's focus and attention; it's possible to think long term while still providing guidance and trying to meet it. But it just doesn't create the right incentives, nor for corporate leader or for investors trying to analyze what's really important for a business. The best guidance you can get is that the company is dedicated to long term value creation as opposed to profit figures for a particular quarter.

acardenal owns shares of Caterpillar, Apple, Berkshore Hathaway and Google. The Motley Fool owns shares of Apple, Berkshire Hathaway, and Google. Motley Fool newsletter services recommend Apple, Berkshire Hathaway, and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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