Does Lowball Guidance Work?

Quarterly earnings guidance is a controversial practice. Critics say it can cause companies to focus on short-term profits, while others argue that it sets reasonable market expectations and enhances stock liquidity while reducing stock volatility and earnings uncertainty. One type of guidance, though, is particularly controversial: “lowballing” or “lowball guidance,” which is guidance so cautious that firms can easily beat it and, perhaps, artificially boost their stock prices.

In a new study, we systematically analyze lowball guidance by exploring four related research questions: 1) how prevalent is this practice, 2) why do firms do it, 3) when do they quit lowballing, and 4) how do  institutional investors and sell-side analysts view it? We examine firms’ extended streaks of repeatedly delivering large earnings-per-share (“EPS”) beats over multiple, consecutive quarters, which we refer to as lowball guidance episodes. Our sample consists of firms that announce a $0.05 EPS beat for at least four consecutive quarters. To further underscore our focus on lowball firms, we construct a control sample of firms that have met or marginally beat ($0.01 to $0.04) their own guidance for four consecutive quarters. Thus, while serving as treatment firms in other studies on earnings guidance, such firms serve as the benchmark in our study and explicitly control for the consistent meet-or-beat phenomenon examined in prior studies.

To the best of our knowledge, the term “lowball” was first used to describe guidance in an online article at that quoted the director of research of First Call as saying,  “lowballing is a tempting thing to do because, for the first three or four quarters, you look like a hero.” His remark suggested that managers use lowballing in the short term, but the market is likely to recognize it after several quarters. Since then, numerous high-profile firms have been recognized as lowball firms by the business press (e.g., Apple, Netflix, LinkedIn, Qualcomm, Target, Marriott, Proctor and Gamble, and General Motors).

Stock prices tend to decline more for earnings misses than they rise for the same level of earnings beats, and steep declines are associated with a high risk of shareholder lawsuits. As a result, firm managers tend to be cautious with their guidance and not over-promise. But we posit that the degree of caution is likely to vary with managers’ confidence in predicting future growth and the composition of a firm’s investor base. Managers are likely to be less cautious when growth is predictable and investors are largely long-term shareholders and overly cautious when growth is highly uncertain and investors are largely short-term investors. Therefore, based on this line of reasoning, we focus on two potential explanations for lowball guidance.

First, firm managers might have genuine difficulty in forecasting next quarter’s earnings because the firm’s operations are uncertain or volatile, especially when coupled with exceptionally high growth or decline in sales or profitability. Guidance that was intended to be reasonably cautious when issued turns out to be overly cautious in light of actual earnings, and this situation repeats over multiple quarters. We refer to this as the “earnings uncertainty” explanation.

The second potential explanation is that managers deliberately provide guidance they expect their firm to exceed by a large margin to appease analysts and institutional investors and to attract new ones. The basic idea is that sell-side analysts who cover a firm with a Strong Buy or Buy rating will be pleased when the firm delivers a large EPS beat at the earnings announcement because that would justify or vindicate the analysts’ positive view of the firm and its stock. Likewise, institutional investors that hold a long position will be pleased when the firm reports a large EPS beat because of the likely positive stock price reaction. We refer to this as the “market appeasement” explanation. We emphasize that the two explanations are not mutually exclusive. It is conceivable, and even likely, that a firm begins an episode of lowball guidance due to earnings uncertainty but later chooses to maintain its reputation of lowball guidance to appease market participants.

Using the criterion that a firm beats its own EPS guidance by at least $0.05 for at least four consecutive quarters, we identify 329 lowball firms, or approximately 11 percent of our 2,953 sample firms during the period of 2001-2017. As a rough measure of the prominence of lowball firms in the stock market, their market capitalization, as a percentage of the market capitalization of all S&P 1500 firms, increased from 9.3 percent in 2001 to 13.6 percent in 2017. Furthermore, about one-third of these firms stopped their initial streaks of lowball guidance but later began another episode, which illustrates the recurring nature of this behavior.

In our test of determinants of lowball firms, we find stronger evidence for the earnings uncertainty explanation than the market appeasement explanation, although we do not rule out the latter. Compared with control firms that just meet or marginally beat their guidance, lowball firms tend to have higher prior sales growth, higher earnings growth, and more volatile earnings, consistent with the earnings uncertainty explanation. There is only marginal evidence that lowball firms have higher ownership by transient institutional investors.

To better understand the benefits and the costs of lowball guidance episodes, we conduct several analyses. First, after initiating lowball guidance, lowball firms continue to have higher ownership by transient institutional investors. They are also more likely to meet or beat analyst consensus than control firms. However, this result is short-lived, as analysts eventually learn to adjust their estimates higher, thus making it harder for lowball firms to beat the consensus. Second, in a short-window analysis of stock market reactions, we find that firms do experience higher abnormal returns for larger EPS beats than smaller EPS beats or exact meets. One-year buy-and-hold abnormal returns are also higher for lowball firms during the year of lowball initiation but not in the subsequent year. These results suggest that there are short-term capital market benefits to issuing lowball guidance, but the benefits dissipate eventually.

Next, we investigate the duration of lowball guidance episodes and the factors that lead to their termination. We find substantial variation in lowball episode duration, with the median at six quarters and the mean at about seven to eight quarters. After that, lowball episodes typically end when a firm either stops issuing guidance altogether, misses its guidance, or begins to exceed its guidance by only a small margin. Consistent with the earnings uncertainty explanation, we find that terminations of lowball episodes are associated with contemporaneous declines in sales and earnings growth.

Our study contributes to and extends the literature on earnings guidance in several ways. First, while prior studies have examined incentives for firms to avoid negative earnings surprises or achieve positive earnings surprises, our study examines their incentives to achieve large positive earnings surprises over many consecutive quarters and tests for consequences against control firms that meet or slightly beat their own guidance over consecutive quarters. Second, our study extends prior studies that have documented positive stock return effects from meeting or beating earnings expectations by examining short- and long-term stock returns associated with repeated large earnings beats. Third, our study relates to prior research that has shown that guidance consistency is more useful to capital market participants than accuracy by exploring the possible motives and consequences of consistent lowballing. Fourth, prior studies have examined single instances of extreme positive earnings surprises and showed that they can attract the attention of analysts and investors, while our study documents the associated outcomes from multi-quarter episodes of large positive earnings surprises for different types (transient, dedicated, and quasi-indexer) of institutional investors. Fifth, the idea of a large EPS beat has not been well established in prior research, despite its common reference among practitioners. Our study is the first empirical study to develop an intuitive, practitioner-oriented definition of lowball guidance to identify lowball firms, document their prevalence, and provide a comprehensive set of analyses on why they initiate or terminate lowball episodes. Finally, to market participants who believe that lowballing is always intentional, our evidence that suggests some lowballing is unintentional and an artifact of earnings uncertainty is surprising.

This post comes to us from Jing Chen at Stevens Institute of Technology School of Business, Michael J. Jung at the University of Delaware, and Michael (Minye) Tang at Florida International University. It is based on their recent article, “Does Lowball Guidance Work? An Analysis of Firms that Consistently Beat Their Guidance by Large Margins,” available here.