Is 'the number' worth it?


Baltimore investment management firm T. Rowe Price Group Inc. beat "the Street" by mere pennies this past quarter, as did Constellation Energy Group. Both watched their stock prices rise in recent days.

Legg Mason Inc., another investment firm, and toolmaker Black & Decker Corp., however, missed "the number" and watched their stocks plummet.

The number is the quarterly earnings estimate. It's what Wall Street analysts, often guided by managers at the companies they watch, project for a company's profit per share of stock.

For all the financial information investors get from companies and the media, snap decisions on whether to buy or sell a stock can come down to that one number.

Companies are whipsawed by the market - at least over the short term - because of their ability or failure to meet the expected number, even when the results are substantially better than in prior quarters.

While the day traders of the 1990s bull market prompted many investors to closely follow earnings hits and misses, some market watchers say the practice has now evolved into excessive ritual. The trend has been exacerbated by the rapid rise of lightly regulated investment pools known as hedge funds, some of which seek to take advantage of market blips caused by "earnings surprises" and which manage more than $1 trillion.

Last month, two leading think tanks called for an end to quarterly earnings guidance, saying the market's obsession with "the number" hurts investors and encourages executives to focus on that short-term objective rather than the company's long-term interests.

But it's a game that market participants generally are willing to play. Many companies complain about the quarterly horse race, yet most provide analysts with specific earnings guidance, or at least a heads-up about expected tax rates, sales or other information.

Companies say they participate in order to be open with investors, though some market observers suspect that many use the system to create success by managing analyst expectations lower and then beating them.

"It's scorekeeping that everyone can understand, and some of it is entertainment. My grandma knows what it means when watching CNBC and they say a company missed its target," said Matthew Orsagh, senior policy analyst at the think tank CFA Centre for Financial Market Integrity. "And companies shouldn't be running their businesses to accommodate that."

The earnings game took hold in the 1990s when Thomson Financial, an information provider, began putting out consensus earnings targets, or an average of analyst estimates of earnings for every company. That's also when Congress passed legislation shielding companies from legal liability for forecasting performance, and more of them started issuing guidance.

The idea was to broaden the flow of information from companies to investors. Earnings per share became a focal point partly because it's a good measure of a company's value, and even critics agree that investors should keep tabs on a company's earnings on an quarterly basis.

The number of companies giving quarterly or annual earnings guidance grew 12-fold from the mid-'90s to about 1,200 in 2001 and then leveled off, according to McKinsey & Co. The consulting firm reviewed 4,000 companies with more than $500 million in revenue.

Not all analysts are happy with the help. Candace Browning, an analyst for two decades who now heads securities research at Merrill Lynch & Co., recently testified on Capitol Hill that projecting a company's future earnings has "overshadowed" an analyst's job.

'An echo chamber'

"This process creates an echo chamber that drowns out investor debate and distills what should be a complex message about a company's operations and performance into a single number - dictated by the company itself," Browning said.

Statistics bear that assertion out. Thomson Financial has found nearly 50 percent of S&P; 500 companies that provide guidance give a number that's below what analysts are projecting, which has led some analysts to lower their numbers. Then, by the time earnings are actually announced, 60 percent of companies beat the latest analyst estimates.

What's more troubling to many investors are the other means that companies employ to beat the Street.

Eighty percent of chief financial officers in a recent survey said they would decrease spending on research and development, advertising and maintenance to meet an earnings target. Fifty-five percent said they would delay starting a new project to do so. The survey by three economists, including John R. Graham of Duke University, queried 400 CFOs.

Superstar investor Warren E. Buffett, long a detractor of CEOs predicting earnings growth, said in his widely read letter to shareholders a few years ago that if tweaking operations to get earnings in line doesn't work, CEOs sometimes resort to accounting shenanigans.

"These can turn fudging into fraud," Buffet wrote. To be sure, some of the accounting manipulation at Enron Corp. was done to beat analyst estimates and keep the stock price up.

Some walk away

A number of companies have walked away from the quarterly earnings game, including Coca-Cola Co. and Gillette Co., which count Buffett's Berkshire Hathaway Inc. as a major stockholder. Companies as diverse as Intel Corp., General Motors Corp., Motorola Inc., and McDonald's Corp. also scaled back guidance.

According to a survey by the National Investor Relations Institute this year, a shift is under way from quarterly guidance to annual guidance.

The trade group found 82 percent of companies provide annual guidance, up from 61 percent in 2005, while those giving it quarterly dropped to 52 percent from 61 percent.

Orsagh of the CFA Centre, which called for an end to company guidance with the Business Roundtable Institute for Corporate Ethics last month, said they want to "change the conversation" on Wall Street, which would require an effort by all players. That includes investors who should act like owners by holding stocks longer and trading less frequently, they said.

The two think tanks point out that the "churn rate" on the New York Stock Exchange, or the annual turnover of shares, hovered between 10 percent and 30 percent from 1940 to 1980, zooming to 100 percent by 2005.

'Whisper number'

But guidance can make markets more stable, defenders say. Without it, they argue, analyst forecasts would be all over the map and the market would be more volatile because companies would be missing the targets more frequently.

Also, many investors are asking why companies should drop guidance now, after the insular world of Wall Street has been forced to open up.

For years guidance from corporate insiders was known as the "whisper number" doled out selectively to analysts and investors. Regulators put a stop to that with Regulation Fair Disclosure, which requires that companies release material information to all investors at the same time.

"The more information, the better as far as efficient markets go," said Shannon Puls, co-founder of, a subscription service tailored to short-term traders.

Puls said the site, which predates the disclosure rule, has always sought out the "whisper number" that analysts show money managers and clients but not Thomson Financial. "That number still exists," he said.

Spokesman Roger Young said Black & Decker issues guidance to give investors "a sense of what the company thinks it's going to do" and that the importance of "hitting the number" appears to be dwindling. The evidence: No investor expressed concern over the company missing the number last quarter after it had met or beaten Wall Street's and its own forecasts for five years, he said. The stock price, however, is down.

Constellation's Angelique Rewers said investors value guidance and that the company "can look out in the future with a greater degree of certainty." That's because its energy portfolio includes multiyear agreements to sell generated power and long-term contracts to buy power.

But for Legg Mason and T. Rowe Price, earnings are much harder to foresee because results depend on where markets head.

Legg Chairman and CEO Raymond A. "Chip" Mason blames hedge funds that "pounce on every bit of information" and the media that "adds fuel to the fire" for the market's fixation on a matter of pennies in earnings per share.

Legg, like Price, doesn't provide guidance, yet the company still took a beating in the market when it fell short of analyst estimates.

"When I see what analysts say our earnings are going to be, I say, 'You know, I've been doing this for 40 years, and I don't even know what our earnings are going to be,'" Mason said.

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