| Investor Relations: It’s all about Managing Expectations | | Print | |
|
For each company listed on the stock exchanges around the world, there is a large audience of investors who has a set of expectations related to the company’s current and future performance. If these expectations are not met, the company’s stock will be adversely affected; if they are met, the stock price will react positively. Sounds simple. Yet, everybody probably will agree that it is not. So, how can senior management set realistic targets or “guide” the market and then manage these expectations through the ups and downs of running a business? An analogy of a public company’s management of investor expectations can be found in an economic event in 2007 that marked the beginning of what is now known as the “Financial Crisis” and the resulting stock market volatility around the world.
Let’s look at a quick snapshot of what happened on the economic front the summer of 2007. Fed Chairman Bernanke publicly remarked in June 2007 that, “the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system1." On August 15, an analyst at Merrill Lynch downgraded Countrywide Financial Corp, citing concerns that liquidity in the mortgage sector could further erode the value of the company. The stock market reacted negatively to this news. Then on August 17, the Fed lowered its discount window rate by 0.5%, which was largely symbolic but nevertheless sent a signal that it was standing-by, ready to intervene in the event of a serious liquidity crunch. In reaction to this news, investors stopped their selling spree and all major indices posted significant gains, and then stabilized.
However, markets experienced another sobering blow with the actual August employment number of a net loss of 4,000, well below economists’ median consensus forecast of an 110,000 gain and even below the Street’s talk of a smaller gain, near 50,000. 2 On top of this, Greenspan’s comment following the job report that “the recent market turmoil is similar to that of 1987 when the Black Monday crash occurred” shook the market even further.3 The messages given by government representatives along with the Fed’s new rate cut were inconsistent and confusing. They created uncertainties in the global financial community, as demonstrated by the discomforting volatility in the marketplace.
So what does this have to do with the everyday life of senior management in a public company? They aren’t managing the economy. But they are managing their businesses and communicating to the financial community. And yes, it is true that they are not running their companies for the analysts. However, as witnessed in the summer of 2007, one analyst’s downgrade (i.e., Countrywide), can severely erode a company’s equity, along with its shareholders’ wealth.
Now imagine the following situation in a public company:
Following the quarterly earnings release, analysts’ headlines read: “Quarterly EPS falls below expectations as management struggles to explain how its revenues have dramatically declined over the same period last year.” The company’s stock dropped by 15% the day after the earnings announcement.
What happened? The market consensus expected a healthy increase in quarterly revenues and a significant improvement in EPS. This consensus was formed following bullish remarks about the company’s growth prospects by the CEO during the previous earnings announcement and similar such remarks in conversations between analysts and senior management during the quarter. Investors were surprised that the actual numbers were so far off from what had been forecasted.
The CEO attempted to backtrack and explain the miss and why they didn’t announce the news sooner. Following a lengthy explanation of what happened, the CFO then interjected that the company would be back on track by the end of the year.
As an analogy to current economic events, the messages given here are also inconsistent and unclear. First, investors want to know when the company learned of this situation and what measures are being taken to improve performance. Not disclosing this information prior to the earnings release and having it as a “surprise” implies that either management didn’t know or didn’t want to tell. Either way this is a no-win situation. In addition, a new bullish message has been given that will cause a new consensus to be formed, probably one that has little chance of being met.
So how are realistic expectations established and managed on a consistent basis?
First of all, it’s important to understand the mindset of a financial analyst or investor who is investing in the equity market. They all are astute in finance and thus are “numbers” oriented. Some are more knowledgeable than others of their target industry. But, one thing is constant across the board: they all base their equity investments on what they think a particular stock price will be in the future.
In addition to peer comparables, the majority of analysts and investors use a DCF (discounted cash flow) model when deciding whether or not to invest in a stock. In laymen’s terms, they look at the revenue projections, costs of operations, and subsequent cash to be generated on an annualized basis over a future period of let’s say 10 years, after which they capitalize the terminal year’s cash flow (assumed to be sustainable in the long-term). They then bring the value of the cash generated back to the present, divide it by the number of shares outstanding, which results in a target share price. If a company’s current share price is above what the DCF model shows, the stock is rated a Hold or Sell. If the current share price is below what the model shows, it represents potential upside and is considered to be a Buy. Simple as that.
Every question an investor or analyst asks goes into the formulation of this model – how will a company grow revenues, manage costs, and generate cash. The answers can come in many forms. There isn’t a magic formula, but the following provides some guidelines that can be adapted to most public companies, regardless of the industry, revenues, market capitalization, and personal style of senior management.
Take a look at your markets, potential growth/decline. Determine how your product or services will be affected. Determine how much you will need to spend to do this. What will the level of your revenues be? How will new products perform? How long will legacy products survive and continue to produce cash? What level of R&D spending is required to prevent obsolescence, to stimulate growth? How many new employees are needed to support anticipated growth? There are many experts on building strategic plans and the purpose here isn’t to instruct how to develop one. Rather, it is to encourage you to have a strategic plan if you haven’t already, and to use it if you do.
If a company cannot or does not wish to communicate on future traditional financial metrics such as revenue growth, EPS, etc., then find something you can predict. New product launches, opening of new manufacturing facilities, employee numbers, and new R&D initiatives are some examples that will give the investor some idea of how to build his model. You can be creative as long as you help the market understand and model accomplishments and future growth.
The bottom line is that it’s all about creating and managing expectations. Give as much information as you are comfortable with, ensuring its accuracy based on your best assessment of the company’s outlook. Be consistent in your messaging, making sure all company spokespeople tell the same story. Be proactive in utilizing many different forums to get your message out. Most important, keep the information flowing. The market doesn’t expect a continuous rosy picture. What it does expect is transparency and openness. Will this make your stock price go up? Not necessarily. But it should limit volatility. And it definitely will establish and reinforce your company and its management’s credibility and make it much easier to tap the financial market for your future capital needs.
1) Bernanke’s remarks to the 2007 International Monetary Conference, Cape Town, South Africa on June 5, 2007
2) CNN Money Online- September 7, 2007
3) Wall Street Journal, September 7, 2007
|
