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Do Companies Adjust Revenue to Meet Investor Expectations?

Jul 5th 2017
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How much weight do investors assign to revenues compared to earnings? It varies considerably among the five major business sectors – and depends just as much on the stage of a company’s life cycle.

That’s a key finding in new research, Revenue Benchmark-Beating and the Sector-Level Investor Pricing of Revenue and Earnings, that was published in the June issue of Accounting Horizons, a journal of the American Accounting Association.

It’s possible that no measure of corporate performance brings more attention than companies’ success or failure in meeting the earnings forecasts of analysts. Yet those findings are hardly foolproof guides to stock performance on a reporting day. It’s not unheard of to see companies report meeting or beating earnings forecasts only to see their stocks drop when facing disappointing revenues.

Stock prices of companies in the technology and health care sectors, for example, have almost doubled the sensitivity to reported revenues (revenue response coefficient, or RRC) that stock prices of firms in other sectors have. In other words, their stocks rise or fall twice as much as other stocks do in response to the amount revenues diverge from what analysts predicted.

But, overall, the five business sectors – technology, health care, consumer, manufacturing, and “miscellaneous other” – show a tendency to exactly meet or slightly beat analysts’ forecasts according to investors’ priorities.

The study, which was conducted by Rong Zhao, assistant accounting professor at the University of Calgary, analyzes quarterly financial reports over a 16 1/2-year span. She found that 16 percent of companies reported revenue that barely met or slightly exceeded analysts’ revenue forecasts following quarters of high RRC. In contrast, only about 9 percent of companies did the same following quarters of low RRC.

However, the pattern was reversed when it came to earnings sensitivity (earnings response coefficient, or ERC). Zhao found that 15 percent of the companies reported revenues that barely met or slightly exceeded analysts’ revenue forecasts following quarters of low ERC, while only 11.5 percent did so following quarters of high ERC.

“Clearly, corporate managers are attuned to what investors are looking for in their companies’ reports and to the weight investors assign to revenues as distinct from earnings,” Zhao said. “To a considerable degree, the revenue they report reflect this.” 

The professor noted that prior research has described the way managers vacillate between an all-growth strategy, where revenues take priority, and a margins strategy, where earnings do.

“But given the fact that company financial results conform as conveniently as they do to what investors are looking for, one also has to wonder about the extent of accounting manipulation in bringing this about,” she added. 

In fact, Zhao’s findings ought to be of value to both investors and regulators. For example, if a tech company or drug company just meets or slightly beats analysts’ revenue benchmarks, there may be less to that achievement than meets the eye, because such companies have a heightened incentive to manage their accounting with precisely that goal in mind. 

A similar motivation may also be at work for companies at relatively early stages of development. Defining companies’ life cycles on the basis of three factors – dividend payout, sales growth, and age – Zhao classified those below the average life cycle of companies in their sector as relatively young. Being relatively young, she said, strengthens the positive association between companies’ RRC and meeting revenue benchmarks.

As for where the balance between earnings and revenues is today, Zhao commented that, “for what it’s worth, I think the general emphasis of the market now is back to growing revenue after several years of focusing on cost reduction during the financial crisis.”