CFOs are obsessed with meeting consensus – so obsessed, in fact, that they are often willing to make decisions that could damage their company’s long-term performance in order to make sure they don’t miss it.
Yet research shows that the stock price of companies which employ earnings management to meet consensus perform worse in the following year than honest companies that miss consensus.
CFOs are obsessed with meeting consensus
Research by a team from Columbia Business School has found that most CFOs would choose to make decisions that could destroy corporate value rather than miss analysts’ consensus.
As a result, they would carry out earnings management to meet consensus – at the expense of their company’s long-term performance.
For example, 80% of CFOs said that they would decrease discretionary spending to meet an earnings target – even though they accepted that such actions can destroy corporate value.
And 55% said they would delay starting a new project to meet an earnings target, even if such a delay can destroy corporate value.
Several interviewed CFOs candidly acknowledged that they have made real corporate sacrifices to hit an earnings target.
Is this obsession justified?
What proportion of companies miss consensus?
An analysis of 180,000 quarterly results over a 17-year period found that:
- 13% of company results reported an EPS that met analyst consensus precisely
- More than 25% of companies beat consensus by $.01 – $.03
- Combined, this means that almost 40% of companies met or marginally exceeded consensus
- Whereas just 15% of the sample missed consensus by $.01 – $.03
So, if you miss consensus marginally, you are in the company of a small selection of poorly-performing companies.
And – to make matters worse – everyone will assume that you did everything possible to meet consensus but failed – creating doubt about your underlying corporate performance and management competence.
So what is the impact if you do?
What is the short-term impact of missing consensus?
In another analysis, a team from the University of Chicago School of Business found that:
- Stocks of companies that hit consensus rose by 1.6% on average over the 3 months ending with the earnings announcement – reflecting investors’ response to management guidance and analysts’ forecast revisions made prior to the final results.
- Those that missed consensus dropped by 5% on average.
- Those that beat consensus increased by 5.5% on average.
Yet within those averages, there is a wide disparity
In fact, research also suggests that some companies get hit hard yet others are not affected at all.
What creates the greatest stock price declines after missing consensus?
Investors respond differently to earnings misses for different companies at different times. Some are punished severely while others escape unscathed. And, interestingly, the size of the consensus miss had only marginal impact on stock price movement.
The Chicago School of Business analysis found that two factors had the greatest impact on the stock price declines of companies that missed consensus:
- Weakness in Company Fundamentals
If the consensus miss is disclosed with a disappointment in sales, cashflow, margin – or with a downbeat management outlook – it invariably leads to significant loss of share price.
- High Growth Expectations
The team at Chicago ranked the companies that missed consensus according to their market-to-book ratio (the ratio of the forward-looking stock price to the historical-based book or equity value per share), and they found that:
- Companies that missed consensus, but had low prior growth expectations, experienced a stock price decline of -3.6%.
- Companies that missed consensus, and had high prior growth expectations, experienced double that decline: -7.3%.
In short, high-growth companies are hit twice as hard as low-growth companies when they miss consensus.
And overvalued stock is hit the hardest.
As a result, it is not in the interest of any company to employ earnings management that camouflages weakness in corporate performance.
In fact, research suggests that companies that are honest to the markets about their performance achieve superior stock performance that those which choose to camouflage corporate weakness with earnings management.
What is the long-term impact of missing consensus?
Sanjeev Bhojraj and a team from Cornell examined what happens to companies that miss the consensus estimate by a penny – without employing earnings management.
They identified such companies by tracking unusual changes in the major expense items that commonly reflect earnings management – accounting accruals, R&D, advertising expenses etc.
They found that manipulating companies that beat consensus received a temporary 3-4% increase in their stock price – but had lost it all by year-end.
But companies that missed consensus by one penny without manipulating earnings did not receive any decline in stock price in the short-term – and a year after the consensus miss, their stock price had increased significantly.
It is most likely that you will risk missing consensus sometime, if you haven’t already.
According to an analysis by Morningstar, for example, just 3% of companies have reported an increase in EPS consistently over a 10-year period.
And only 3% have reported an increase in free cash flow consistently over a 5-year period.
So you will probably miss consensus one day.
But earnings management can both damage your stock price and erode your corporate value.
As a result, rather than camouflaging weak performance under earnings management, companies are advised to communicate the issue to the markets with a clear plan to address the weakness.
If you deliver on that plan, your stock will emerge stronger.
Reputation is a Research and Strategy Consulting Firm that advises CEOs and Boards of Public Companies how to achieve Fair Valuation for their Company’s Stock.