This article is a discussion of a survey of senior financial executives that was carried out by Graham, Harvey, and Rajgopal. The survey was administered through multiple media and received an overall response rate of 10.4%. The questions were designed to probe the executives’ thoughts and opinions on how likely they or their firm would be to destroy value in pursuit of short term financial performance. The categories that the questions addressed were: the importance of earnings, earnings benchmarks, meeting earnings benchmarks, failure to meet earnings benchmarks, sacrificing value to meet earnings benchmarks, and smooth earnings.
The cash flows that a company produces are what investors are really purchasing when they invest in a company. This knowledge is not reflected in the sentiment of CFOs. The survey showed that nearly two thirds of respondents believed that earnings are the most important metric in the eyes of outside stakeholders. It was noted from the data that unprofitable and younger firms tended to favor cash flows, and private firms were also more likely to favor cash flows. The fact that public companies are more likely to see earnings as the most important metric may speak to the pressure that financial markets place on companies to perform. The authors speculate that earnings, particularly EPS, is seen in the eyes of senior finance executives to be important to outside stakeholders because it is comparable across companies and it gets media coverage. The use of this one single metric also makes it easier for analysts to make predictions on future performance.
As earnings are the most widely accepted performance metric, there are numerous methods for benchmarking. The idea of earnings benchmarks allows managers to compare their performance to something; the survey showed that the most important benchmark was same quarter last year with a 85.1% of respondents selecting this. This answer was unexpected as CFOs also stated that missing the analysts estimates leads to the biggest drop in share price, but it was also noted that current quarter compared to last year is the first item in a press release. The next category addressed the importance of meeting earnings benchmarks; 86.3% of respondents believed that meeting benchmarks builds credibility with the capital markets, with 80% agreeing that meeting benchmarks helps maintain or increase the firm’s stock price. According to survey responses, individual managers strive to meet benchmarks to maintain their own personal reputation. Maintaining employee bonuses and lowering the cost of debt were seen as unimportant.
When asked about the consequences of failing to meet their benchmark, 80.7% of CFOs cited the uncertainty about future prospects and the perception that there is something unknown wring with the firm as the top two consequences. The CFOs commented on how businesses ore often run in such a way that they will produce smooth earnings with goals that will be perpetually attained. CFOs are scared of what the market will infer about their company is a target is missed. In order to avoid missing a target, it was found that 80% of CFOs would decrease discretionary spending on R&D, advertising, and maintenance to hit their earnings target; this is clearly short term behavior that is destroying shareholder value in the long run. These actions are a quick hit play to maintain the share price, but will undoubtedly have consequences. Taking it even further, 55.3% of CFOs would delay starting a project to meet earnings targets, even if the delay was clearly going to destroy value. This data indicates that managers are willing to sacrifice cash flows for accounting earnings. It is speculated that these actions are the result of managers preferring real economic actions over accounting games to meet earnings due to fear from previous scandals.
Smooth earnings paths are another area that CFOs tend to be willing to make sacrifices for. 96.9% of respondents stated that they prefer smooth earnings, even though the underlying business may be far more volatile. The reason for this is to make investors think that the company is less risky than it may actually be which can result in lower costs of capital due to a lower perceived risk premium. CFOs in the survey stated that they would sacrifice value to maintain smooth earnings.
The fact that executives manipulate their earnings numbers to maintain or improve their stock price is scary in the context of maintaining the integrity of capital markets, but when they are willing to destroy long term value to make their performance appear to be strong, that is detrimental to a market where people feel that they are able to trust available information. Missing the analysts’ earnings consensus and having volatile earnings are said to have similar effects on share price, and are therefore equally avoided even if real value needs to be destroyed to make that happen. In the context of building and maintaining integrity of the markets, CFOs do a major disservice by placing retail investors at the bottom of the list when they produce their financial information. Companies do this because it is thought that analysts are young and they will overreact if they see things like volatile earnings, so they are hidden. It is also noted that because institutional investors are evaluated against each other, if earnings are missed and one fund begins selling off stock, the other in its peer group will likely follow. Also, hedge funds may have measures in place to sell a stock if it drops below a certain price, and a missed target could trigger the same and a chain reaction following.
In order to solve these problems, the authors propose that firms change their reporting habits by moving to principles rather than rules based accounting standards, remove quarterly EPS guidance, and less emphasis on quarterly earnings. They also state that it is important to maintain integrity in reporting, and some major changes in corporate governance. I think that the most interesting suggestion is that of making institutional investors take a more active role in how management perceives their short term actions will be received. If major funds confirm that they will not sell off a stock due to a missed target as long as there is a value creating activity behind it, managers would not be so short term in their behavior. I think that although a good idea, it would be very difficult to sufficiently empower retail investors.