One of the defining features of the stock market boom of the late 90s was the intense focus on companies making “the number.” There were harsh consequences for the stock price if a company failed to meet, or more likely, exceed Wall Street’s earnings expectations.
Apparently that mentality continues on today. Jeff Matthews heard on a conference call a CEO state that his foremost goal in the new year was to meet “guidance.” Matthews continues on:
Now, if Mr. Bender honestly thinks that the “number one” objective of his company should be “to hit our guidance” for the sake of Wall Street’s Finest and their precious earnings models, then he is about as far removed from what really makes a company great as a CEO can be.
Lest you think this is an isolated case, we would point you to a paper published in the November/December 2006 issue of the Financial Analysts Journal.* John R. Graham, Campbell R. Harvey and Shiva Rajgopal note in their paper, “Value Destruction and Financial Reporting Decisions” that value destroying decisions by corporate management is in fact commonplace.
Their paper draws these conclusions from an extensive survey of CFOs of hundreds of publicly traded companies. They find earnings (and earnings guidance) continue to be important guidelines for companies. So much so that firms will take action to avoid missing earnings guidance. These decisions can include foregoing projects that are perceived to be ultimately value enhancing.
From their paper (p. 38):
The findings of our survey on financial reporting practices are startling. That participation in the earnings game is pervasive may not be surprising, but that the majority of companies are willing to sacrifice long-run economic value to deliver short-run earnings is shocking. Yet, these actions are not even considered to be a problem by many CFOs…
While shocking, these results are probably not all that surprising. However it might give us a clue as to the surge of private equity transactions of late. If the perceived burdens of public ownership are so strong that it affects seemingly rational economic decision making, then another ownership structure like private equity may help ameliorate this problem. We are not saying that is the sole (or even main) reason for the private equity boom, but it bears watching.
*This FAJ paper is based on earlier work including this NBER working paper and this SSRN version.