The Guidance Game-P/E ratios,is there more to it than meets the eye?
LoD:
Thanks to your guidance (get it it?<g>),I am taking the liberty to post the article for the thread to see,in case any of them missed it.
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(Courtesy:Fortune Magazine)
If you understand the rules, you can see why P/E ratios aren't always what they appear to be.
Erick Schonfeld
There is a game that corporate officers like to play with Wall Street analysts, a "game of nods and winks," as Securities and Exchange Commission chairman Arthur Levitt describes it. Let's call it the guidance game. Though the game itself is getting more elaborate, the basic rules are simple. Analysts have to guess how much a company will earn every quarter. But a company is allowed to provide the analysts with clues, or so-called guidance, about what it thinks earnings will be. This guidance number usually shows up as the consensus estimate among analysts. If the company's actual earnings meet or just beat the consensus, both the company and the analysts win: the stock goes up, and everyone looks smart. The game might not sound so hard, but it requires a lot of cooperation. Companies are under enormous pressure to achieve the consensus earnings estimates, while analysts rely on those same companies to help them form their earnings expectations in the first place. Problems can arise, of course, because even for the companies, earnings are often unpredictable.
Despite its difficulty, this game just keeps getting more popular. A survey this year by the National Investor Relations Institute found that 79% of 2,600 public companies always or usually give guidance to analysts, up 10% from 1995. Part of the reason companies are giving more guidance, explains NIRI president Louis Thompson, is that "analysts beg for it."
More interesting perhaps is that guidance is no longer simply a matter of managing earnings expectations; it is also a matter of managing earnings surprises, or the difference between reported earnings and consensus estimates. "Earnings surprises have become common currency in the information flow," explains Stanley Levine, director of quantitative research at First Call, "but now what is being looked at are the pre-announcements before the surprise." According to First Call, through mid-November of this year there were 2,555 earnings pre-announcements, vs. 715 three years ago. This is further evidence that companies are managing Wall Street's expectations more aggressively.
Another way to think about guidance, pre-announcements, and earnings surprises--and a way to quantify the effects on stock valuations--is to look at what Mike Kwatinetz, head of technology research for Credit Suisse First Boston, calls "guidance bias." Some companies are consistently conservative in the guidance they give analysts, producing positive earnings surprises on a regular basis. Others give consistently optimistic guidance, producing negative surprises. Those that regularly exceed the consensus estimates have a positive guidance bias, and those that fall short have a negative bias. Of course, not all companies have a bias. Some, such as General Electric and Procter & Gamble, get it just right, reporting earnings that fall, on average, within 1% of their guidance.
Here comes the tricky part: Companies that exhibit a positive or negative guidance bias may be distorting their forward price/earnings multiples, since they're affecting the "E"--the expected earnings--in the P/E ratio.
Dell Computer, for instance, based on consensus 1999 earnings estimates, has a mountain-high P/E of 44, whereas Compaq Computer's P/E is a sea-level 20. Even taking into account Dell's higher expected-earnings growth rate and Compaq's challenges with smoothly integrating its acquisition of Digital Equipment, Dell still looks expensive compared with Compaq. But the bottom half of Dell's P/E is based on the company's own earnings guidance, and over the past three years the company's actual earnings have averaged 63% higher than that guidance. If that pattern persists next year, that means Dell's real 1999 P/E is 27 instead of 44. Compaq, on the other hand, has a guidance bias of negative 20%, giving it an implied P/E of 24 instead of 20. Kwatinetz believes the bias of both companies will moderate this year. Even so, Dell still seems less expensive and Compaq more so.
A positive guidance bias can be a good indicator of conservative management, and vice versa. Says Kwatinetz: "Companies that have a pattern of being conservative probably have more room in the numbers." Generally, it is easier for companies with fast-growing revenues, such as Dell, Microsoft, or even the Gap, to be flexible with their numbers. But just because a company has had a positive guidance bias is no guarantee that it will continue to have one. Investors should take particular note of companies whose bias changes. Coca-Cola, for instance, is normally a paragon of predictability, with a guidance bias close to zero. But this year it has been slammed by the Asian slowdown, making its guidance bias slip into negative territory. Whether that is an anomaly or the start of a new pattern remains to be seen.
Today the guidance game is fine-tuned down to the penny, raising the question of whether companies are doing analysts' work for them. The SEC's Levitt is concerned that companies are entering a gray area "where numbers represent more desire than fact." NIRI's Thompson suggests that for the most part, "companies should report what is, and analysts should report what is likely to be" (apparently a novel concept to most market participants). Perhaps companies, analysts, and investors would all be better off if they put the game away. But where's the fun in that?
pathfinder.com
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