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

Abstract

CEOs are in a difficult bind with Wall Street. Managers up and down the hierarchy work hard at putting together plans and budgets for the next year and quite often when those plans are completed top management discovers that the results fall far below what Wall Street expects. CEOs and CFOs are therefore left in a difficult situation. They can stretch to try to meet Wall Street's expectations or prepare to be punished if they fail. All too often top managers react to the situation by encouraging or mandating middle and lower level managers to redo their forecasts, plans and budgets to get them in line with external expectations. In some cases, fearing the results of missing the Street's expectations, managers start the budgeting process with the consensus expectations and mandate that internal budgets and plans be set so as to meet them. Either way this sets the firm and its managers up for failure if external expectations are, in fact, impossible for the firm to meet.

We illustrate, with the experience of Enron and Nortel, the dangers of conforming to market pressures for growth that are essentially impossible. We emphasize that an overvalued stock can be as damaging to the long-run health of a company as an undervalued stock, a proposition that few managers are familiar with. An overvalued stock sets in motion a variety of organizational behaviors that often end up damaging the firm. It does not have to be this way. Ending the expectations game requires that CEOs reclaim the initiative in terms of setting expectations and forecasts. To begin, CEOs must say no to the earnings guidance game and reverse recent practices in which analysts took the lead in driving industry forecasts, and companies complied. Managers must make their organizations more transparent to investors, so that stocks can trade at close to their intrinsic value. Doing so means CEOs and CFOs must inform the market when they believe the market expectations cannot be met and that the stock is, therefore, overvalued.

Keywords: Value Maximization, Overvaluation, Incentives, Managing Earnings, Analyst Expectations, Managing Wall Street, Earnings Guidance, Financial Reporting, Budgeting Process

JEL Classification: G14, G29, L21, M10, M40, M46