Earnings Guidance - Needed?

A majority of the companies across the world provide earnings guidance. It's in the form of a target number that the company projects it will reach in terms of revenue, profit, growth etc. It is provided by companies because providing guidance increases liquidity for companies that might otherwise be ignored, and liquidity helps to reduce volatility. Also companies like to tell their stories themselves rather then letting analysts speculate. Another reason is earnings are a key part of corporate performance. Such information is important for the market to know.

And yet, the evidence continues to build that the theory of earnings guidance is all wrong. There are many who look at guidance in a negative light. They contest that it imbeds perverse incentives (to manage the numbers rather than the business), relies on dubious assumptions (that earnings should be stable), and feeds into a short-term mentality. The stock market existed for centuries before guidance became common practice in the early 1990s, so it can certainly function without it. Also research by McKinsey actually suggests that for large companies earnings forecasts actually increase volatility because the fact of hitting or missing creates trading action.

Earnings guidance is not knowledge. It is just an educated guess, or rather, an aspirational one that far too many companies will fold, spindle or mutilate themselves to meet. Take the example of Enron for the worst-case scenario of guidance gone amok. Companies like the New York stock Exchange (NYSE), Berkshire Hathaway, Google, and JP Morgan Chase do not provide a earnings guidance. Good economic performance is a process, not a number. All these companies provide other details to the market like medium-to long-term goals for each of its businesses, return on equity, company's priorities, strategy, issues and finances. Even the Chinese Communist Party gets this concept. Like Warren Buffett and the gang at Google, China has come to recognize good management requires that numbers be servants, not masters. Their newest five year plan does not feature an economic growth target.

Companies ought to re-look at the need to provide earnings guidance and see if other parameters can be provided instead.

The EV/EBITDA ratio

An alternative to the P/E ratio that is often used is the valuation multiple or enterprise multiple called EV/EBITDA. EV stands for Enterprise Value and takes equity as well as debt into consideration. EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. The advantage of this ratio over P/E ratio is that it takes debt into account in the numerator and the denominator is not distorted by the effects of individual countries' taxation policies. The enterprise multiple looks at a firm as a potential acquirer would. Obviously, a company with a low enterprise multiple can be viewed as a good takeover candidate.

Keep in mind though that enterprise multiples can vary depending on the industry. Therefore, it's important to compare the multiple to other companies or to the industry in general. High growth industries command higher enterprise multiples and slow growth industries have lower multiples.

All about P/E ratio

When you are evaluating a company for its value from an investment perspective one ratio that everyone looks for and talks about is P/E. You will see everyone referring to it and talking about it in the equity markets. Here are some answers to common questions -

What is the P/E ratio?: P/E stands for Price to Earnings ratio. It is the price of an equity share of the company divided by the earnings of the company against each equity share. Let us look at each of these parameters in detail.

• Price of an equity share (P): This is the prevaling price of the equity share of the company in the market today. Pls note this is different from the face value of the share of the company. A share of face value 10 may be priced at a premium to (above) the face value or at a discount to (below) the face value.
• Earnings per share (E): It is calculated as the profit earned for the most recent 12 month period per each outstanding share. For example if a company makes a profit of 100,000 and has 1000 shares outstanding, the earnings per share are 100.

What does P/E denote?: From a financial perspective one would like to pay a price for an investment equivalent to the profit (earnings) that can be derived from the investment. So ideally one would like to have a P/E of 1. Since the earnings of a good company are bound to grow (increase), one might want to pay a price greater than the current earnings of the company. So the P/E becomes > 1. If the company is not making any profit, or making a loss for that matter P/E becomes < 1. So essentially P/E denotes what the market thinks of the company's growth prospects. If it is a high growth company one would like to pay a steeper price than the current earnings and if the company is low or medium growth then obviously the price will be lower. Also if the company is growing its earnings quickly the P/E will become low. Obviously then a lower P/E denotes a value investment (value investments will be covered in a later blog).

What is the right P/E?: There is no one number that can be specified as the appropriate P/E for a company. Various factors like business environment, economic growth rate, regulations, demand, projected growth rate, etc. contribute to the determination of what one feels as the correct P/E for an investment. Since its a ratio of Price to Earnings, lower the value, the cheaper the company is to own.

Word of Caution: Know that the P/E can be manipulated! Since the concentration is on lowering the P/E ratio, it can be manipulated by increasing the denominator. Lets say company X has 1000 shares outstanding at a price of 800 per share and earnings of 100,000. Current P/E of company X is 800/100=8. Now company X decides to buy back 200 of its shares at 800. The new P/E of X is 800/125=6.4! So even though the company did not actually grow its earnings, it managed to lower its P/E just by buying back its shares!