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Weak Guidance vs. Beating Consensus

| | Posted in: Fundamental Valuation

Conventional wisdom is that company management can maximize stock price by issuing weak guidance for future earnings that sets low expectations, and then reporting earnings that beat the low expectations. Does evidence support this belief? In their September 2010 paper entitled “The Stock Price Effects from Downward Earnings Guidance Versus Beating Analysts’ Forecasts: Which Effect Dominates?”, Lynn Rees and Brady Twedt investigate the net effect on stock price of downward earnings guidance that enables a subsequent positive earnings surprise. Using a sample of 8,635 guidance-earnings observations for 2,751 firms during 1993 through 2006, along with a matched control sample, they find that:

  • Most earnings guidance (63%) is negative and successful in setting low expectations. Firms that issue (do not issue) earnings guidance subsequently meet or beat consensus analyst forecasts 79% (55%) of the time.
  • Controlling for all earnings news, downward earnings guidance depresses quarterly stock returns. In other words, the effect of downward guidance on stock price more than offsets the premium for later meeting or beating consensus analyst forecasts.

In summary, evidence indicates that the negative effect of downward earnings guidance tends to be stronger than the positive effect of subsequently beating low expectations. Managing earnings downward is a net losing proposition.

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