The Transparency Strategy
New research from two Johnson professors shows that how often a firm issues earnings guidance can tell a lot about the company
Firms that issue frequent guidance about future earnings are more likely to be accurate in their forecasts than companies that rarely issue earnings guidance, according to a new study by two accounting professors at the Samuel Curtis Johnson Graduate School of Management at Cornell University. Robert Libby, the David A. Thomas Professor of Management and professor of accounting, and Sanjeev Bhojraj, faculty director of the Parker Center for Investment Research and professor of accounting, collaborated on the research with the Holly Yang, an assistant professor at the University of Pennsylvania’s Wharton School, who received her PhD from Johnson in 2010.
The researchers also found that companies that frequently issue earnings guidance tend to become more accurate in their predictions over time, apparently the result of learning from their experience.
These firms are more likely to have institutional ownership, the study says, probably because institutional investors tend to prefer companies with greater disclosure transparency.
“These firms are following a strategy,” Libby said. “One might call it a strategy of transparency and improved disclosure. It seems to fit with their broader attempts to build the reputation of the company.”
The findings appear in the working paper, “Guidance Frequency and Guidance Properties: The Effect of Reputation-building and Learning-by-doing.” The results caught the attention of the Wall Street Journal, which cited them in a June 29, 2012 article.
“We argue that guidance frequency is an important variable for two reasons: reputation-building and learning-by-doing,” the researchers write in the working paper. “We suggest that frequent guiders are more likely to represent a type of firm that is attempting to develop a reputation for enhanced disclosures through their guidance issuances.”
Publicly traded companies issue earnings guidance at dramatically different rates. Some announce earning projections frequently throughout the year, while others issue guidance only when they are expecting negative results in a quarter.
The researchers studied the activities of 1,750 publicly traded firms between 1995 and 2005. Using public databases, the researchers calculated how frequently these firms issued earnings forecasts. The researchers determined how accurate these forecasts were by comparing the earlier projections with actual firm performance data.
According to the research, earnings per share predicted by the most frequent guiders were off by an average of 0.7 percent, while companies least likely to issue earnings guidance missed estimates by an average of 4.3 percent.
The researchers attribute these results to what they call “learning by doing.” By issuing earnings guidance more frequently, firms appear to be gaining experience that helps them to improve the accuracy of their forecasts.
The researchers found that firms that issued guidance infrequently tended to disclose only bad news, while frequent guiders reported both good and bad news. An early warning about poor earnings can be a way for firms to soften the blow of negative official earnings reports and to head off future lawsuits, the researchers point out.
The working paper states that “frequent guiders, motivated by the desire to build or maintain a reputation for transparency, are likely not to limit themselves to disclosures aimed at reducing litigation, but also focus on trying to better inform capital markets.”
The reputations of firms were calculated using several measures. The researchers used rankings of firms on Forbes magazine’s “best companies to work for” list, which is based on employee surveys. Data from the American Customer Satisfaction Index, which is based on interviews with U.S. consumers, were used to gauge firms’ standing among its customers. Firms that frequently issued guidance scored high on both of these measures.
The researchers concluded that how frequently a firm issues earnings guidance is an important characteristic of a company.
“Our results are consistent with frequency being an important classificatory variable, with frequent guiders representing a class or type of firm that develops a reputation for enhanced disclosures through their guidance and therefore have different incentives and processes that affect the properties of the guidance and learning over time,” the researchers write.
Said Libby, “These firms have decided that they benefit from having a policy of more transparent disclosures and better disclosures.”