How reliable is earnings guidance?

If management provides earnings guidance, then surely the numbers are crystal clear? Here are four problems from 2018 which show why earnings guidance must be treated with caution.

To value a company accurately today, you need know the cash flow it will generate ten years from now. That's because a company is worth the discounted sum of every single cash flow it will ever deliver - into perpetuity.

Nobody can be certain of a company's tenth year's cash flow figure or indeed any other, which is why valuing a company is inherently imprecise. If you're a value investor, though, you're implicitly estimating this stream of cash flow whenever you buy a stock.

This is why valuation shortcuts are often used, with the price-earnings ratio (PER) the most well-known (despite its faults). You've probably seen Intelligent Investor use a 'forecast' or 'prospective' PER to flag value. But always remember that a PER is only ever a shortcut; a company's long-term cash flows - difficult to estimate as they are - are the basis of every valuation.

The forecast PER is based on our estimate of earnings for the financial year. Our earnings estimate may or may not be consistent with the earnings 'guidance' that management sometimes provides, or with broking analyst numbers (often called 'consensus' earnings estimates).

As analysts it's part of our job to determine how useful management's guidance is. Sometimes guidance is not particularly useful - or reliable - at all. In the wake of reporting season, here are four examples of how management's earnings guidance was problematic in 2018.

Problem 1: Guidance only applies to the current financial year

Remember that it's a company's long-term cash flows that matter. If management provides guidance for just one year - the usual practice - you shouldn't just ignore subsequent years.

Media monitoring company Isentia (ASX:ISD) is a case in point here. In October 2017 management said that 2018 earnings before interest, tax, depreciation and amortisation (EBITDA) would be $32m-36m, and reconfirmed this figure all the way up to July 2018.

Earnings and cash flow

Companies often provide earnings guidance with reference to earnings before interest, tax, depreciation and amortisation (EBITDA). But remember that the interest, tax, depreciation and amortisation expenses do matter. We've seen companies provide EBITDA guidance but then - upon releasing their results - report a tax rate that's much higher than market expectations.

Be aware of companies - such as InvoCare - whose current year EBITDA will be flat or slightly down but where depreciation and interest expense is rising quickly. In these cases the net profit line can fall by a much greater percentage than EBITDA.

Finally, remember that while investors focus on earnings (net profit), it's long-term free cash flow that drives valuation. While net profit can be a proxy for free cash flow, if the latter is significantly different from the former, make sure you understand why (for example, fast-growing companies typically consume cash as they grow).

But Isentia's revenues were under pressure and, based on company announcements, we determined that copyright costs might increase sharply again too. The resignation of the chief executive was another red flag (see Isentia loses its head). Yet broker consensus numbers for 2019 assumed EBITDA would be $33m, essentially flat on management's 2018 guidance.

When management announced 2019 EBITDA guidance of $20m-25m, it shocked the market. Make sure you always think about financial years beyond management's current guidance, particularly if the business is under pressure.

Problem 2: The goalposts can change

Less commonly, management will provide multi-year guidance, often as part of a strategic plan. Usually this takes the form of revenue growth or margin targets rather than the explicit numerical guidance Isentia provided.

Education provider Navitas (ASX: NVT) is an example here. In April 2017, as part of its Strategy Day, Navitas's management forecast annualised revenue growth of 5% and an EBITDA margin of 18% by 2020.

Based on market forecasts at the time, this implied Navitas would earn EBITDA of almost $190m in 2020. However, a number of business changes - including contract losses and business divestments - mean the number is now more likely to be $160m-170m.

It was a lesson that targets are all well and good, but forecasts based on upon them are potentially meaningless if the goalposts shift. And a new managing director - as in Navitas's case - can more easily disclaim previous targets based on decisions they've made.

Problem 3: Guidance isn't provided on a like-for-like basis

When it comes to management providing earnings guidance, most analysts assume it's on a like-for-like basis (excluding acquisitions, for example). This makes intuitive sense as obviously changing an input affects an outcome.

However, this isn't always quite how management always sees it. Take funeral provider InvoCare (ASX: IVC), which gave earnings guidance of 'low single-digit operating EBITDA growth' in February 2018. Back then the company had not yet begun its regional acquisition strategy to counter the recently listed Propel Funeral Partners (ASX: PFP).

Horse sense
Warren Buffett: 'The CEO who misleads others in public may eventually mislead himself in private'. 

When it came to InvoCare's interim results in August, however, management's updated (and lower) guidance included earnings from acquisitions. On a like-for-like basis that implies the business is performing worse than before.

InvoCare's guidance was also clouded by accounting changes. Management's original guidance was couched in terms of the pre-accounting change earnings. The positive effect of these accounting changes will make it more difficult to determine InvoCare's underlying performance next year.

Problem 4: Guidance excludes charges or writedowns

Laboratory services group ALS (ASX: ALQ) forecast an underlying 2018 net profit range of $135m-145m in November 2017. But while it's sensible to derive an underlying earnings figure, management's definition of underlying might be rather different from yours.

In ALS's case, 'restructuring and one-off charges' (as well as a few other costs) were excluded from management's definition. When ALS reported its 2018 underlying net profit of $142m in May, the figure excluded $15m of restructuring and one-off charges. As results over the past five years have all been subject to 'one-off' charges, surely that's stretching the definition?

Make sure you understand what's included and excluded from management's definition of guidance, including whether it changes from year to year. Often it's in management's interests to make the earnings - or earnings increase - look as favourable as possible.

So how reliable is earnings guidance, really?

As you can see it should be taken with a grain of salt. Management teams are often just as prone to overconfidence as investors - if not more so - so businesses under pressure should be scrutinised carefully.

Reading between the lines is an important skill. Management has an incentive to present company information in the best possible light. Examine all the negatives and assess whether they're a bigger issue than management is letting on.

Above all, remember that forecasts - management or otherwise - are just that. The results a company ends up producing a year, five years or ten years down the track can vary significantly from market expectations. Understand what drives the business, and you're more likely to avoid unpleasant surprises.


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