13 May 2010Working Paper Summaries

Just Say No to Wall Street: Putting A Stop to the Earnings Game

by Joseph Fuller and Michael C. Jensen

Over the last decade, companies have struggled to meet analysts' expectations. Analysts have challenged the companies they covered to reach for unprecedented earnings growth, and executives have often acquiesced to analysts' increasingly unrealistic projections, adopting them as a basis for setting goals for their organizations. As Monitor Group cofounder Joseph Fuller and HBS professor emeritus Michael C. Jensen write, improving future relations between Main Street and Wall Street and putting an end to the destructive "earnings game" between analysts and executives will require a new approach to disclosure based on a few simple rules of engagement. (This article originally appeared in the Journal of Applied Corporate Finance in the Winter 2002 issue.) Key concepts include:

Managers must confront the capital markets with courage and conviction.
Managers must be forthright and promise only those results they have a legitimate prospect of delivering, and they must be clear about the risks and uncertainties involved.
Managers must recognize that an overvalued stock can be damaging to the long-run health of the company, particularly when it serves as a pretext for overpriced acquisitions.
Managers must work to make their organizations more transparent to investors and to the markets.
To limit wishful thinking, managers must reconcile their own company's projections to those of the industry and their rivals.
While recent history may have obscured the analyst role, managers should not simply presume that analysts are wrong when disagreement occurs. In fact, analysts have a vital monitoring role to play in a market economy.

Author Abstract

Putting an end to the "earnings game" requires that CEOs reclaim the initiative by avoiding earnings guidance and managing expectations in such a way that their stocks trade reasonably close to their intrinsic value. In place of earnings forecasts, management should provide information about the company's strategic goals and main value drivers. They should also discuss the risks associated with the strategies, and management's plans to deal with them. Using the experiences of several companies, the authors illustrate the dangers of conforming to market pressures for unrealistic growth targets. They argue that an overvalued stock, by encouraging overpriced acquisitions and other risky, value-destroying bets, can be as damaging to the long-run health of a company as an undervalued stock. CEOs and CFOs put themselves in a bind by providing earnings guidance and then making decisions designed to meet Wall Street's expectations for quarterly earnings. When earnings appear to be coming in short of projections, top managers often react by suggesting or demanding that middle and lower level managers redo their forecasts, plans, and budgets. In some cases, top executives simply acquiesce to increasingly unrealistic analyst forecasts and adopt them as the basis for setting organizational goals and developing internal budgets. But in cases where external expectations are impossible to meet, either approach sets up the firm and its managers for failure and in the process value is destroyed. 9 pages.