a professional investor looks at earnings forecasts

CFA Institute

A Professional Investor Looks at Earnings ForecastsAuthor(s): George S. BissellSource: Financial Analysts Journal, Vol. 28, No. 3 (May - Jun., 1972), pp. 73-78Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4529460 .

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A Professional Investor Looks at Earnings Forecasts by George S. Bissell, C.F.A.

"It is important to recognize the fact that although it is unethical, by code, for an AICPA member to associate himself with a financial forecast in any way, and althougji forecasts are specifically dis- couraged by SEC regulations, that management does not seem to feel similarly bound by any such restrictions in their public pronouncements. In terms of accepted practice, there are no ethic.al barriers preventing management from making certain forecasts public. The SEC and the AICPA could change their present position and recognize the de facto practice of financial forecasting merely by changing their regulations and codes. The users of financial statem.ents would be better off if current practice were recognized and controlled with forecasting methods subject to independent review." *

The statement quoted above is that of a corporate officer who prepares financial statements. The point of view is refreshing. In effect, he says: 1) Those preparers of financial statements who are reluctant to reveal to the investment community a sense of their expectations should be urged to do so. 2) It is high time the SEC came to grips with the fact that, whereas investment realities relate to future expectation, registration requirements dwell on historical fact. 3) Independent bodies, such as the AICPA, should be given th.e responsibility of commenting on preparers' material to add a further sense of reliability and objectivity to the corporate reporting process. 4) The profes.sional financial analyst should deemphasize his role as a reporter (What are you going to earn this year?) and con- centrate more on the critical evaluation aspects of his responsibilities in the investment process.

I regard financial forecasting as an extension of the. broader responsibility of corporate disclosure. Furthermore, it is a widely accepted assumption that buyers and sellers of securities today depend to a substantial degree on future expectation as a

major aspect of the investment decision-making process. The conclusion seems inescapable that the more broadly reliable information that is dis- sem.inated throughout the investment community, the greater will be the tendency of security prices to remain at or near "true investment value," con- tributing to a more stable price pattern. Hence the issue today is not whether but how to undertake appropriate financial forecasting, and I would add, to whom and by what means.

The challenges of financial forecasting are substantial. To the issuer, the challenges may include appropriate time frames for financial forecasting, the amount of detail to divulge, the degree of prob- ability of the forecast, and the reliability of the assumptions behind it.t Further, what are the costs of preparation? When will a forecast hurt a corporation competitively? To wh.at degree will financial forecasts increase the corporation's legal liabilities?

Each corporation undoubtedly has. its own internal forecast yardsticks and appropriately so, for each corporation's business differs and the, sophistication and reliability of the internal forecasting mechanism vary widely from corporation to corporation.

To the user of financial forecasts the challenge is even greater for, in my view, little thinking has been done as to how much information is actually needed to make an investient evaluation. For years analysts have sought increased disclosure under the superficial assumption that more is better. In my opinion, formal disclosure of internal budgets is probably substantially more than is necessary. Indeed, general discussion through one medium or another of the elements involved in future revenue and cost assumptions underlying these forecasts and the probabilities involved in such assumptions may well be sufficient for investment evaluation.

Who Are the Users of Financial Information?

Before discussing how to undertake financial forecasting, one should understand the user market and its needs. In terms of numbers and sophistication, the user market in my view resembles a

* R. Gene Brown, "Ethical and Other Problems in Publishing Financial Forecasts," The Financial Analysts Journal, March-April 1972, p. 42.

GEORGE S. BISSELL, C.F.A., is a Senior Vice President of Massachusetts Financial Services and Director of Research. Mr. Bissell is also President of Massachu- setts Income Development Fund, one of the five funds managed by Massachusetts Financial Services. He is a former President of the Financial Analysts Fed- eration.

t In the article footnoted above, Brown discusses each of these challenges at some length.

FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1972 0 73



Responsibility in Financial Forecasting

triangle. At the top of the triangle are a few soph- isticated securities analysts who have devoted a substantial part of their lives to the understanding and evaluation of a small number of industries and corporations. Formal education usually includes an advanced degree (M.B.A.) plus a sufficient number of years of study to thoroughly understand industry characteristics, corporate structure and management capabilities. This level of profession- alism in my view can be compared to a management consultant. The major contribution of the analyst is not his comprehension, but rather his ability to interpret and judge the information available in a way that leads to a meaningful decision.

The security analyst often serves institutions, of course, and their market force is overwhelming. The NYSE's study of public transactions of 1969 reveals that there has been a substantial increase in institutional trading activity on the Exchange. The institutions, which in 1960 contributed only 40 per cent of all transactions on the Exchange, jumped to 62 per cent in 1969, and a current estimate of 70 per cent may not be out of line.

At the bottom of the triangle are millions of indi- vidual investors (including former SEC Chairman Cohen's favorite "Aunt Minnie"). Perhaps less obvious, however, is the fact that this broad investing public also has the professional analyst available via the broker-dealer community. In recent years this community has increased its research effort in terms of both quality and quantity. Thus, while it is important to direct attention to Mr. and Mrs. John Q shareholder (and I agree with the SEC's determination to give them equal opportu- nity to participate), nevertheless the desired results of appropriate evaluation of securities and conse- quent stability of securities prices will be achieved most efficiently through communication with pro- fessionals in the investment community.

The conclusion to be drawn from this review of the users of financial information is that corporate disclosure, including financial forecasts. should be tailored to all levels of sophistication in the mar- ketplace on a continuing and regular basis, and include both in-depth financial forecasting for the professional investor and disclosure of the poten- tially dangerous and over-simplified earnings per- share expectations for the general investing public.

Forecasting for Securities in Registration

Forecasting responsibility can usefully be dis- cussed under two headings: 1 ) material desired in conjunction with the issue of public securities; and 2) suggested procedures for normal ongoing financial forecasting.

The material required for registration of new securities should include aspects of the future. Since investment decisions depend to a large degree on evaluation of future expectations, it seems difficult to understand why forecasting is not permitted and indeed encouraged by the SEC at all times, even during a public offering. I fail to see any difference between day-to-day and new-issue investment decision making on the part of the investor. Indeed, it is ironic that the SEC insists on a blackout period at the most crucial moment of a public offering, in order to avoid "conditioning the public mind or arousing public interest in the issuer or its securities." t Such a posture, while laudable as an at- tempt to protect the unsophisticated investor, still does not protect him from the hard-sell efforts of a broker-dealer community spurred by the increased financial incentives of an underwriting. Indeed such a blackout process actually favors the professional investor who is far less dependent on controlled background information on future expectations to draw reliable conclusions regarding the securities' probable future potential.

If the concept of forecasting for new public issues is accepted, consideration should be given to the British system for financial disclosure. While by no means foolproof in protecting the public against an erroneous forecast or a decline in stock value, nevertheless, adopting the British system should improve investment decisions and benefit the investing public as a whole.

Exhibit I includes relevant material from the Accountant's Reports on Profit Forecasts, July 1969, of the Institute of Chartered Accountants in England and Wales. Exhibit II includes several samples of forecast expectation paragraphs ex- tracted from both English and Dutch prospectuses. There is more detail in the English prospectuses than the Dutch. As far as the Netherlands is concerned, according to Article 15-1(f) of the Amsterdam Stock Exchange, an offering circular should contain "all further data desired for making a judgment on the state of affairs and the financial situation of the issuing company in the past, the present as well as the near future."

In view of the diversity of corporate operations

-SEC Release No. 5180, Securities Act of 1933- Gtidelines for Release of Information by Issuers whose Securities are in Registration, dated August 16, 1971.

74 n FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1972



EXHIBIT I

Accountants' Reports on Profit Forecasts - July 1969

It is emphasised that profit forecasts necessarily depend on subjective judgements and are, to a greater or less extent, according to the nature of the business, subject to numerous and substantial in- herent uncertainties, which increase markedly the further forward in time the forecasts stretch.

In consequence profit forecasts, as defined in paragraph 1 above, are not capable of confirmation and verification by reporting accountants in the same way as financial statements which present the final results of completed accounting periods and there is no question of their being 'audited', even though the reporting accountants may also be the company's auditors. It is important that reporting accountants should make this clear when they accept instructions to review the accounting bases and calculations for profit forecasts, and in the wording of their report they should take care to avoid giving any impres- sion that they are in any way confirming, underwriting, guaranteeing or otherwise accepting responsibility for the ultimate accuracy and realisation of forecasts. Moreover, bearing in mind their special status and authority, reporting accountants should do or say nothing to encourage directors, third par- ties or the public to place mistaken reliance on statements as to future profits the achievement of which must always be subject to uncertainty.

(b) it should be clearly established that the reporting accountants' instructions and responsibility for reporting under the Code are confined to the accounting bases and calculations for the profit forecasts, as distinct from the assumptions, including the commercial assumptions, upon which the directors have based their forecasts

(c) because profit forecasts are subject to increas- ing uncertainty the further forward they reach in time, reporting accountants should not normally undertake to review and report to directors on profit forecasts for more than the current accounting period, and, provided a sufficiently significant part of the current year has elapsed, the next following accounting year.

Main points to be considered in reporting accountants' review:

In carrying out their review the main matters to which the reporting accountants will direct their attention are as follows:

(a) the nature and background of the company's business

(b) the accounting practices normally followed by the company

(c) the assumptions on which the forecasts are based.

(d) the procedures followed by the company for preparing forecasts.

The procedures followed by the company for preparing forecasts:

In carrying out their review of the accounting bases and calculations for forecasts, and the procedures followed by the company for preparing them, the main points which the reporting accountants will wish to consider include the following:

(a) whether the profit forecasts under review are based on forecasts regularly prepared for the purpose of management, or whether they have been sep- arately and specially prepared for the immediate purpose

(b) where profit forecasts, are regularly prepared for management purposes, the degree of accuracy and reliability previously achieved, and the frequency and thoroughness with which estimates are revised

(c) whether the forecasts under review represent the management's best estimate of results which they reasonably believe can and will be achieved as distinct from targets which the management has set as desirable

(d) the extent to which forecast results for expired periods are supported by reliable interim accounts

(e) the extent to which the forecasts are built up from detailed forecasts in respect of the main divi- sions or lines of activity of the business, distinguish- ing where possible between those which may be re- garded as showing a proved and consistent trend and those of a more irregular, volatile or unproved nature

(f) how the forecasts take account of any material exceptional items, their nature, and how they are presented

(g) whether adequate provision is made for foreseeable losses and contingencies

(h) whether working capital appears adequate for requirements as shown by properly prepared cash flow forecasts; and where short-term finance is to be relied on, whether the necessary arrangements have been made and confirmed

(i) whether the forecasts have been prepared and presented on acceptable bases consistent with the accounting principles and practices adopted by the company in previous years, and if not, whether the fact and effects of any material change of basis are made clear.

FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1972 E 75



to long-range forecasts. By contra,st, a high technology company may be faced with uncertain costs and unknown revenues, so that detailed forecasts may be either meaningless or misleading.

Hence I sympathize with those corporate offi- cials concerned about revealing publicly budgets primarily designed for internal consumption. The professional analyst is well aware of these uncertainties and the low degree of reliability that may be incorporated in certain, aspects of internal corporate budgets. Nevertheless, the uncertainty problem. does not relieve the executive of his responsibility of discussing these factors in a more general way with the security analyst so that the analyst can understand his thought process.

In view of the diversity of the user market, it is obvious that the level of discussion should vary with the sophistication of the audience according- ly, i.e., conversation either in private or large groups of financial analysts can be substantially more detailed than press releases or shareholder publications. Carrying this theory to its logical conclusion, however, it is important for management to communicate with the general investing public at a level that is meaningful. Rather than

being content with the argument that nondisclosure avoids confusion in the minds of shareholders, management should provide some expectation of earnings-per-share. Perhaps the best way to con- vey a sense of forecast uncertainty to the general investing public would be to issue a range of earnings-per-share expectations with the breadth and time frame of the forecast reflecting management's estimates of the degree of reliability.

In regard to frequency, there should be some formal disclosure at least on a quarterly basis. Th.e investment community and shareholders are used to quarterly reports and depending on the pace and volatility of the business, previous forecasts can be either modified or reaffirmed briefly. While there is no best method of communication, the following is a suggestion for a typical program of corporate forecast communication with the financial community:

1. ANNUAL REPORTS. While the prime purpose of the annual report is to disclose to shareholders a review of the operations for the preceding year, of more importance is management's assessment of the near future. While the subject matter (ma- teriality) and degree of detail should remain the

EXHIBIT III

The Pure Oil Company Proxy Statement for Special Meeting of Shareholders, July 2, 1965

Negotiation of Union Oil Merger Terms and Basis Therefor:

In working out the merger arrangements, Union consulted with Dillon, Read & Co. and Blyth & Co., Incorporated, investment banking firms. Pure has had the benefit of advice and a report from Duff, Anderson & Clark, investment analysts. Their letter of opinion is reproduced on page 6.

Report of Independent Investment Analysis:

Duff, Anderson & Clark Industrial Investment and Financial Analysts

208 South LaSalle Street Chicago, Illinois 60604

May 19, 1965 Board of Directors The Pure Oil Company Palatine, Illinois

Gentlemen:

In accordance with your request, we have reviewed the terms of the proposed merger of The Pure Oil Company into Union Oil Company of California.

We have also, at your request, reviewed two alter- native proposals considered at the time you deter- mined to proceed with negotiations of definitive de- tails of the Union merger, one of which contemplated the sale of Pure's assets and the other a merger of Pure with another oil company; and also a recent communication from Ashland Oil & Refining Com- pany outlining a plan for the sale of Pure's assets. The results of our review and analysis of the fore- going are set forth in detail in our Report dated April 22, 1965, and supplementary letters dated May 4, and May 17, 1965.

In our opinion the proposal for the merger of Pure into Union is fair and equitable; and your decision to proceed with the Union merger was and is, in our view, in the best interest of Pure's shareholders. We consider the Union merger arrangement to be su- perior and preferable, from the standpoint of a shareholder of Pure, to any of the proposals or possi- bilities referred to in the preceding paragraph. Our belief is that the investment quality of the Union preferred to be issued on the merger to Pure shareholders is such that, under normal market conditions, it should command a higher valuation than the market has been placing on Pure common.

Very truly yours, Duff, Anderson & Clark

FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1972 fl 77




prerogative of management, most companies could expand on future expectations in their annual report. As a starter, why should they not at least discuss the divisional sales and earnings by cate- gory required in the 10-K? They could also appropriately comment on expectations for the economy as a whole, on conditions in the industries served and on specific corporate events tending to make corporate results either better or worse than those for the industry as a whole.

While it is not necessary for corporations to include in their forecasts every detail, it would be appropriate to include an earnings range for the following calendar year. The major purpose of disclosing an earnings range is not to inform the professional analyst but to establish throughout the entire investment community a reasonable framework of expectations for the company over the foreseeable future. Once this framework has be- come established and well known, it becomes less likely that private discussions among analysts during the subsequent year will lead to problems with use of inside information. While some corporate executives feel that the earnings forecasts can be


prerogative of management, most companies could expand on future expectations in their annual report. As a starter, why should they not at least discuss the divisional sales and earnings by cate- gory required in the 10-K? They could also appropriately comment on expectations for the economy as a whole, on conditions in the industries served and on specific corporate events tending to make corporate results either better or worse than those for the industry as a whole.

While it is not necessary for corporations to include in their forecasts every detail, it would be appropriate to include an earnings range for the following calendar year. The major purpose of disclosing an earnings range is not to inform the professional analyst but to establish throughout the entire investment community a reasonable framework of expectations for the company over the foreseeable future. Once this framework has be- come established and well known, it becomes less likely that private discussions among analysts during the subsequent year will lead to problems with use of inside information. While some corporate executives feel that the earnings forecasts can be

dangerous in that it may increase legal liability, the forecast, if handled with appropriate modifying conditions and clauses, will reduce the risk of misleading the investing public, as well as the risk of disclosing inside information.

2. QUARTERLY REPORTS. Quarterly reports, while essentially reviewing items of immediacy and con- taining a short time span in corporate history, should, in the interest of stabilizing the company's stock price, address themselves briefly to changing or reaffirming earlier longer term forecasts.

3. ANNUAL MEETINGS. Annual meetings are the least efficient corporate obligation today; yet, with a little planning, annual meetings can be the cornerstone of communication with the investing public. Management will often spend hours in preparation for an annual meeting attempting to minimize the chance of embarrassment by a question from a shareholder on the floor. It would be more fruitful for management to address itself to the problems and prospects of the company, par- ticularly those relating to, the financial expectations for the coming fiscal year. *

dangerous in that it may increase legal liability, the forecast, if handled with appropriate modifying conditions and clauses, will reduce the risk of misleading the investing public, as well as the risk of disclosing inside information.

2. QUARTERLY REPORTS. Quarterly reports, while essentially reviewing items of immediacy and con- taining a short time span in corporate history, should, in the interest of stabilizing the company's stock price, address themselves briefly to changing or reaffirming earlier longer term forecasts.

3. ANNUAL MEETINGS. Annual meetings are the least efficient corporate obligation today; yet, with a little planning, annual meetings can be the cornerstone of communication with the investing public. Management will often spend hours in preparation for an annual meeting attempting to minimize the chance of embarrassment by a question from a shareholder on the floor. It would be more fruitful for management to address itself to the problems and prospects of the company, par- ticularly those relating to, the financial expectations for the coming fiscal year. *

When to sell short against the box concluded from page 81

long term earnings bias should have a bearing upon the reinvestment decision.

When, after a rise in price, the hedger decides to close out the short position, he may either:

1 ) deliver the security held long at the time of sale and thereby incur a long term capital gain, or

2) repurchase the security more than thirty days after the date of sale, deliver the repur- chased lot and thereby incur a recognized long term capital loss, or

3) repurchase the security less than thirty days after the date. of sale, deliver the repur- chased lot and thereby incur an unrecog- nized capital loss, which loss may be used to increase the cost basis of the lot held long and not used to close out the short position, or

4) do any two or more of the above with vari- ous units of the security to arrive at a desired net capital gain or loss position.

When to sell short against the box concluded from page 81

long term earnings bias should have a bearing upon the reinvestment decision.

When, after a rise in price, the hedger decides to close out the short position, he may either:

1 ) deliver the security held long at the time of sale and thereby incur a long term capital gain, or

2) repurchase the security more than thirty days after the date of sale, deliver the repur- chased lot and thereby incur a recognized long term capital loss, or

3) repurchase the security less than thirty days after the date. of sale, deliver the repur- chased lot and thereby incur an unrecog- nized capital loss, which loss may be used to increase the cost basis of the lot held long and not used to close out the short position, or

4) do any two or more of the above with vari- ous units of the security to arrive at a desired net capital gain or loss position.

Most closed end investment companies offer their shareholders the right to subscribe for additional shares at the lower of asset or market value on a given date and up to the amount of the year end income and capital gains dividends on the shares owned. The shareholder who elected to subscribe for additional shares realizes short term capital gain if, after the company's stock sells ex- dividend, he sells the number of shares to be received short against the box for more than the cost thereof and closes out the short position by delivery of the shares representing the dividend.

Deferred Delivery

Occasions arise where an owner wishes to establish the selling price of a security but is not then able to deliver it in transferable form. Inability to promptly obtain physical possession of the certifi- cate or a document required to effect transfer are instances requiring any sale to be made short. Under these circumstances the security owned cannot be used as a pledge for the security bor- rowed. *

Most closed end investment companies offer their shareholders the right to subscribe for additional shares at the lower of asset or market value on a given date and up to the amount of the year end income and capital gains dividends on the shares owned. The shareholder who elected to subscribe for additional shares realizes short term capital gain if, after the company's stock sells ex- dividend, he sells the number of shares to be received short against the box for more than the cost thereof and closes out the short position by delivery of the shares representing the dividend.

Deferred Delivery

Occasions arise where an owner wishes to establish the selling price of a security but is not then able to deliver it in transferable form. Inability to promptly obtain physical possession of the certifi- cate or a document required to effect transfer are instances requiring any sale to be made short. Under these circumstances the security owned cannot be used as a pledge for the security bor- rowed. *

7 FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1972 7 FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1972



a professional investor looks at earnings forecasts

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