Why a Cent (or Two) Matters
Continuing with the theme from my last post about investors and investment expectations, here’s a question I often get from perplexed students or executives: “If the value of a company is truly represented by the present value of the future cash flows, why does the stock price of a company often fall drastically – sometimes by as much as 20-25% or more – when the company misses the earnings per share (EPS) consensus analyst estimate by only one or two cents?”
I really love this question because it is a great question. Truly, it makes one genuinely question whether everything they taught us about future cash flows and present value calculations in finance classes was simply interesting theory, but not very practical. If the consensus analyst estimate is $0.50 per share, and the company comes in at $0.48 per share, why is everyone so upset? Maybe future cash flows really aren’t that important? Maybe short term EPS is all that matters?…..maybe, but my opinion is maybe not 😉
When I became the CFO of Baxter International in 1993, the first thing I did was visit our largest shareholders and numerous security analysts to take the time to understand their perspectives. I really learned a lot by simply listening.
Here are some lessons I have never forgotten:
1) If the consensus analyst estimate is something that the company believes is not achievable, then why doesn’t management communicate what is achievable? Management is responsible for setting shareholder targets that they can achieve. As one shareholder told me, “Harry, when a CEO or CFO tells us that the guidance is X, and they don’t achieve X, why is that my fault? Why are we the bad guys? I’m sorry, I thought management was going to do what they said they would do? And by the way, if there is a good reason that the expectation is no longer realistic, how about communicating that so we can understand what is really going on?”
2) Another shareholder had an interesting perspective, “Harry, there are clearly many ‘judgment calls’ in the accounting for a large company. If a company guides us to $0.50 per share, and they only achieve $0.48 per share (despite all the judgment calls management made), the company must be ‘wound very tight’ with no flexibility whatsoever. What does that suggest about what’s really going on in the company? What does that indicate for company performance going forward?”
3) One more shareholder perspective (and this one really bothers some CEOs): “Harry, if the company cannot predict what they are going to deliver 90 days from now, what credibility do they have predicting what they will achieve five or ten years from now?”
Here’s the key point I learned…..the stock price of a company doesn’t decline 20-25% simply because the company missed the quarter by one or two cents…it declines because of what that performance does to the average analyst expectations for the next 5 to 10 YEARS!!! Credibility is key….and as I often say to my students…..are we managing for the Short-Term or the Long-Term???? My opinion, as always, is “YES”!!!!
Feel free to let me know what you think……as I always say, these are opinions, not answers 😉