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PROF. MICHAEL C. JENSEN: HARVARD BUSINESS SCHOOL
Just say no to wall street!
Why CEOs should not conform to market pressures for unrealistic growth targets
Issue Date - 30/05/2012
 
First there were whispers and informal advisories to favoured analysts of what to expect in coming earnings announcements. Then the conversations became more elaborate, engendering a twisted kind of logic. No longer were analysts trying to understand and analyze a company so as to predict what it might earn; instead the discussion revolved around the analysts’ forecasts themselves. Will expectations be met? What will management do to ensure that? Rather than the forecasts representing a financial by-product of the firm’s strategy, the forecasts came to drive those strategies. While the process was euphemistically referred to as “earnings guidance,” it was, in fact, a high-stakes game with management seeking to hit the targets set by analysts—and being punished severely if they missed.

In 2009, SEC recognised that private conversations between executives and analysts had become extensive, with analysts gaining access to critical data not otherwise broadly available to shareholders. The new regulations on fair disclosure addressed the mechanics of the conversation, but did little to change its underlying logic. The result has been blizzards of filings and dozens of press releases, and many more company-run conference calls. But such changes in the outward forms of corporate disclosure have done little if anything to deflect the underlying momentum of the earnings guidance game. Nevertheless, there are some encouraging signs. In the past, a few courageous CEOs – notably, USA Networks’ Barry Diller and Gillette’s Jim Kilts – have attempted to put a halt to the earnings game by simply saying no. In a recent SEC filing, Diller balked at the sophisticated art form known as managing expectations, saying publicly what many have said privately for a long time: “The process has little to do with running a business and the numbers can become distractingly and dangerously detached from fundamentals.”

An Overvalued Stock Damages a Company
Witness the part that Wall Street’s rising expectations played in the demise of once high-flyers like Enron, Cisco, and Nortel. With analysts pushing these companies to reach for higher and higher growth targets, the managements of the companies responded with actions that have generated long-term damage. To resolve these problems, managers must abandon the notion that a higher stock price is always better and recognise that an overvalued stock can be as dangerous to a company as an undervalued stock. The proper management of investor expectations means being willing to take the necessary actions to eliminate such overvaluations.

Over the last decade companies have struggled more and more desperately to meet analysts’ expectations. Caught up by a buoyant economy and the pace of value creation set by the market’s best performers, analysts challenged the companies they covered to reach for unprecedented earnings growth.

 
Executives often acquiesced to increasingly unrealistic projections and adopted them as a basis for setting goals for their organisations. There were several reasons executives chose to play this game. Perhaps the most important was favourable market conditions in many industries, which enabled companies to exceed historical performance levels and, in the process, allowed executives and analysts alike to view unsustainable levels of growth as the norm. Adding to favorable conditions and exceptional corporate performance was a massive, broadbased shift in the philosophy of executive compensation. As stock options became an increasing part of executive compensation, and managers who made great fortunes on options became the stuff of legends, the preservation or enhancement of short-term stock prices became a personal (and damaging) priority for many a CEO and CFO. High share prices and earnings multiples stoked already amply endowed managerial egos, and management teams proved reluctant to undermine their own stature by surrendering hard-won records of quarter-over-quarter earnings growth. Moreover, overvalued equity “currency” encouraged managers to make acquisitions and other investments in the desperate hope of sustaining growth, continuing to meet expectations, and buying assets at a discount with their overvalued stock.

Parallel developments in the world of the analysts completed a vicious circle. Once analysts were known to a handful of serious investors and coveted a spot on Institutional Investor’s annual All-American team. In recent times, analysts became media darlings. An endless parade appeared on an increasing array of business programming. The views of celebrity analysts were accorded the same weight as the opinions of leading executives. Analysts Mary Meeker and Jack Grubman were quoted in the same breath and, more important, credited with the same insight as Cisco’s CEO John Chambers and Qwest’s Joe Nacchio. With the explosion in the markets came an explosion in analyst compensation, as leading analysts shared in the bonus pools of their investment banking divisions and thus had incentives to issue reports favorable to their banks’ deals. Analysts with big followings, a reputation built on a handful of good “calls,” and an ability to influence large investment banking deals sold by their firms commanded multi-million dollar salaries. In sum, analysts had strong incentives to demand high growth and steady and predictable earnings performance, both to justify sky-high valuations for the companies they followed and to avoid damage to their own reputations from missed predictions.

In too many instances, too many executive teams and too many analysts engaged in the equivalent of liar’s poker. Many will say, “So what? If overly aggressive analysts drove executives to create more shareholder value faster, what’s the harm?” What they fail to recognise is that this vicious cycle can impose real, lasting costs on companies when analyst expectations become unhinged from what is possible for firms to accomplish. As the historic bankruptcy case of Enron suggests, when companies encourage excessive expectations or scramble too hard to meet unrealistic forecasts by analysts, they often take highly risky value destroying bets. In addition, smoothing financial results to satisfy analysts’ demands for quarter-to-quarter predictability frequently requires sacrificing the long-term future of the company. Because the inherent uncertainty in any business cannot be made to disappear, striving to achieve dependable period-to-period growth is a game that CEOs cannot win. Trying to mask the uncertainty inherent in every industry is like pushing on a balloon – smoothing out today’s bumps means they will only pop up somewhere else tomorrow, often with catastrophic results.

          

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