Earnings Forecasts: The Uses Of Pseudo-Precision

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Impressed by the precision of a company’s earnings forecast? New study urges caution

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 cents.
  • 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 previously forecast.

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 results presented 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 guidance).”

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.

Article by Academy Of Management

CONTACT: Ben Haimowitz (718-398-7642)

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