Why Do Companies Provide Earnings Guidance? And Why Does it Matter So Much?
Sandbagging, Conspiring, De-Risking
When most large public companies report their quarterly earnings, they'll also provide an estimate for what those earnings and other financial drivers should look like in the next quarter, and for the rest of their fiscal year. For some companies, that “guidance” can be more important to investors than the actual report. For example, a few days ago Oracle reported revenue growth in line with analyst expectations, earnings slightly ahead, but they guided next quarter's revenue growth to +5-7%, compared to expectations of +8%. Shares dropped 14% the next day as a result.
This raises a couple questions: why do companies provide guidance in the first place? Where does it come from? And why do investors care so much?
There are a few different ways companies provide guidance, both formally and informally:
In earnings reports, as discussed above, they'll often provide numbers for the next quarter and the rest of the fiscal year. The typical guidance approach is to start with a wide range for the full-year number, and then to tighten up that range while raising the low end throughout the year. But sometimes guidance will be messy—a company might say that next quarter will be worse than expected and the full year will be better, for example, if costs and revenue shift between quarters. (Sometimes they will call this out; airlines will note if scheduled maintenance moves a major cost from one quarter to another, and hotel companies will mention the impact of holidays that can move between quarters.)
Some companies provide intra-quarter guidance updates. These are often bad news; a company might report earnings in July with positive numbers, and then update investors in mid-September to say that things aren't going as well as expected. In some industries, like the airline industry, there's a regular practice of essentially providing a brief guidance update right at the start of the quarter (before formally reporting earnings and providing next quarter's guide a few weeks later).
And some companies provide longer-term guidance, either as a regular feature of investor communications or as a one-off when they hold an "investor day" conference, a sort of day-long explanation of the business coupled with a stock pitch. Sometimes, this guidance looks a lot like a longer-term version of the usual annual guidance, with a 2026 earnings per share range instead of a 2023 number. And sometimes it's more vague; a company might provide an estimate for roughly how big sales can get with their current model, and what they think margins will look like at that point, but most of the numbers will be preceded with a tilde and the dates will be fuzzy, too.
Yet another form of guidance, less accessible to retail investors, is management's intra-quarter commentary. This often happens at conferences, where there's a dance as analysts try to ask questions that will help them project near-term trends better while the company tries to avoid violating Reg FD. An analyst might, for example, ask about the "exit rate" (i.e. the growth rate at the end of a quarter) in order to assess guidance. If a company grew 5% last quarter, guided to 7% growth for this quarter, but also says their exit rate was 7% at the end of last quarter, there's a bit of room for them to beat the guide in the upcoming quarter. On the other hand, if they gave the same guidance but their exit rate at the end of the quarter was 9%, it implies that they saw a bump in growth that they expect to (or have already seen) decelerate.
When is guidance higher-impact? There are two general cases.
First, the higher a company's growth, the more informative guidance is. Suppose a company is growing at 35%, and most people model a 5% step-down in growth per quarter until it stabilizes at 10%. In ten years, revenue will be up 509%. If they update their guidance to +30% growth this year, and everyone retains their current assumptions, the net impact is that growth for the decade drops to 419%. A 5% drop in near-term growth leads to a 15% decline in long-term revenue, and if the company has fixed costs this might translate to a decline in long-term earnings of 20% or more. This is one reason stocks can dive so much in response to comparatively small shifts in guidance.
A second impact that guidance has is that it hurts management's credibility when they guide down: it means they're either bad at predicting industry trends or failing to execute on their plans, so that can be good for another price drop.
Another reason guidance can matter is the calendar effect. A company operating on a calendar quarter that reports Q3 earnings in early November has already been through almost half the quarter when it reports. Depending on the sales cycle, it may already know what most of the rest of the quarter will look like. An industry like cruise lines, where customers book months in advance, has locked down most of its revenue well ahead of when that revenue gets reported (though such companies do see swings in revenue, and magnified swings in P&L, when close-in bookings are stronger or weaker than expected). A SaaS company with recurring contracts that get negotiated in advance also has a pretty good idea of what the quarter will look like by the time it reports. In that case, the actual quarterly revenue number is often noisier than the guidance, since it can be driven by contracts landing in an unexpected quarter or by a last-minute churn surprise. In most such cases, guidance is a better picture of how the company is doing than the actual earnings report.
So, why do companies guide? Why don't they just report what they have to, and tell investors they're on their own? There are a few motivations at work:
CEOs are human, and they like impressing people. One way to reliably impress people is to exceed expectations, and the easiest way to do that is to make sure those expectations are low. Some companies do this to an absurd degree (for a long time, the way to estimate Booking.com's key metric, FX-adjusted bookings, was to take the guidance range they gave and add 7% to it; about a decade ago, Apple announced that it was switching from providing extremely conservative point estimates in guidance to providing a range that actually reflected a realistic view of what the business could achieve). Sandbagging is gratifying, but eventually investors get sick of it.1
One fun theory about guidance is that companies use it to coordinate soft cartels. If everyone in the airline industry publicly says "We're being very disciplined about growth and we don't want to add excessive capacity," they'll constrain supply and tickets will be more expensive. If they also say, as airlines sometimes do, that they will defend their market share in key hubs at all costs, then that, too, is a way to suggest that competitors stay out.2
Guidance is also a form of investor relations. Specifically, it's an implicit promise to investors that the company will try to avoid any unpleasant surprises for them. The more carefully a company guides, and the more willing they are to update guidance, the more stock prices will continuously reflect incremental changes to reality. Suppose a company realizes late in the quarter that they're not going to hit their numbers, and that next quarter will be even worse. They could just announce bad earnings and a bad guide all at once on earnings day. But if they announce the bad earnings in advance, then instead of one big drop in the stock there are two smaller ones, one from the earnings and one from the next quarter's guidance. That doesn't change the volatility of the underlying business at all, but it does reduce the volatility of the stock. And if the stock price bounces around less, its risk-adjusted return is higher, which means that it deserves a slight valuation premium.
Companies aren't required to provide earnings guidance, and many of them don't. Berkshire Hathaway is famously averse to doing it, for example, and when Google went public they wrote a fairly Berkshire-flavored letter to investors saying, among other things, that they did not plan to give earnings guidance. They've stuck with this for a surprisingly long time. But companies are motivated to keep investors happy, both for the abstract moral reason that they are entrusted with investor capital and for the more prosaic reason that they may need to raise more of it and will struggle to do so from irate investors. (Google and Berkshire might have different guidance philosophies if they weren't free cash flow machines whose biggest capital allocation problem is what to do with all the cash their profitable businesses throw off.) Guidance will stay useful, but will also remain a source of variant views, because companies will always be torn between telling investors what they need to know and what they want to hear.
Read More in The Diff
The Diff has covered guidance directly and indirectly in a few posts, including:
This piece ($) covers companies pulling back from guidance during the pandemic.
In this one ($), we look at how tech company guidance has evolved in an era of slower growth.
In this writeup of Diversified Energy ($), we look at the challenges of investor relations in an unpredictable industry (made more challenging in this case because the company in question has its operations in the US but, oddly, lists shares in the UK and reports financials in pounds).
1. Some companies say that their guidance is, in fact, their internal estimate of what growth will look like in the next quarter. But they do tend to beat it anyway, and sometimes provide a scorecard showing how well they do. One possibility is that this is the estimate the CEO is working with, but that people lower in the org chart are sandbagging to make themselves look good instead.
2. This is hard to prove, because it's most feasible in industries with high fixed costs and boom-and-bust cycles. But those are also industries where, after the "bust" part of the cycle, the surviving CEOs are usually the ones who are cautious about expansion (all the aggressive ones lost a bunch of money and got fired). So this kind of language in guidance should predict high prices even if none of the airlines listen to each other's conference calls.
Share Capital Gains
Subscribed readers can participate in our referral program! If you're not already subscribed, click the button below and we'll email you your link; if you are already subscribed, you can find your referral link in the email version of this edition.