It turns out the effort that many finance chiefs have made over the years to show consistent earnings growth may have been for naught. According to a new study by McKinsey & Co., there is no evidence that smooth earnings produce higher returns for shareholders. Indeed, says Tim Koller, a McKinsey partner and one of the study's authors, the actions that companies take to ensure smooth earnings in the short-term may ultimately hurt them.
The study, which compared the total shareholder return of 135 companies from the S&P 500 with above-average earnings volatility against the same number of companies with below-average volatility, found no correlation between total return and earnings fluctuation. Indeed, the sample set included low-volatility companies with low shareholder return and high-volatility companies with high returns.
Another surprise, says Koller, was how few businesses produced consistent earnings growth. During the period studied (1998–2007), 460 of the companies in the S&P 500 reported a loss. Walgreen showed the most stable earnings, with growth between 14% and 17% from 2001 to 2007. After that, Anheuser-Busch, Colgate Palmolive, Cisco, and PepsiCo were the next most stable, but each had a year with a loss. "Companies just aren't able to continue earnings increases year after year for more than a couple of years," says Koller.
What typically happens, he says, is that a well-run company can eliminate some operating costs over a period of a few years, which usually boosts earnings for a time. "By then, you have conditioned yourself and your investors to achieve this nice, steady earnings growth," says Koller. "Then you start cutting things like marketing and product development to extend the growth for a couple of years, but eventually that hurts you, because you fall behind the competition."
For CFOs who may feel pressure to produce predictable earnings increases, Koller says, "you have to be honest with yourself about whether, if you try to reduce the volatility, it will hurt you three to five years down the road." He also notes that many investors, particularly the more sophisticated ones, don't expect smooth earnings and are often skeptical of them. "CFOs can dig deeper into what investors are really telling them. Find the more sophisticated investors and see what they think about the volatility," says Koller.
While management teams don't want to appear as if they have no control over the business, some forces, such as rising commodity prices or a weak economy, can be controlled or offset only up to a point. "The nature of the economic world is that things are not smooth," says Koller.
How accepting shareholders are of that reality is, of course, another matter.