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Beware of what lurks if companies fixate on estimates

By ELLEN SIMON
Published August 4, 2006

The gaming of company earnings is so widespread, it has created a condition known as "the cockroach effect." When a company that usually meets earnings estimates misses a quarterly target by a penny, the stock gets creamed. The reason: Investors assume it used every trick in the accounting rule book to get that close, yet failed.

"If you're managing earnings, and you miss by a penny, there must be a lot there," said Jeffrey Diermeier, president and CEO of the CFA Institute. Just as seeing one cockroach is a sign there are many more, accounting tweaks seldom travel alone.

The CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics recently issued a set of recommendations crafted to end what they call "short-termism," one symptom of which is the boosting and busting of a stock based on its quarterly earnings.

The day traders of the last decade may be gone, but the minute-by-minute mentality has lasted: TVs at corporate headquarters show second-by-second ticks of the company's stock price, and management gets so caught up in quarterly numbers, it neglects the long term.

Consider: In a 2005 survey of more than 400 financial executives, 80 percent said they would decrease discretionary spending on such areas as research and development, advertising, maintenance and hiring to meet short-term earnings targets and more than 50 percent said they would delay new projects, even if it meant sacrifices in value creation, according to the Journal of Accounting and Economics.

The organizations' boldest suggestion is an end to quarterly earnings estimates. Instead, they'd like to see companies provide more meaningful, and potentially more frequent, communications about strategy and long-term vision.

Some companies have jumped off the quarterly treadmill. Progressive Casualty Insurance Co. provides ratios that effectively give investors the company's operating margin, a disclosure that has lessened stock market reaction to any one announcement.

"We don't do quarters," Washington Post Co. chairman and CEO Donald E. Graham said in 2004. "Quarterly earnings are not in the top 100 things you should care about if you want to value the company. ... If you care about that sort of thing, you shouldn't own our stock."

There are other ways to break the short-term cycle:

- The organizations are working on a recommendation for a model earnings release, which would standardize earnings reporting. It would contain the company's earnings under Generally Accepted Accounting Principles, a summary balance sheet and a summary cash flow statement.

- Because earnings numbers include so many estimates, giving a reporting company so much wriggle room, former Securities and Exchange chairman William Donaldson suggested companies release a range representing quarterly earnings and report what assumptions they used to reach those numbers.

[Last modified August 4, 2006, 06:14:02]