WHY COMPANY GUIDANCE MATTERS

Understanding how corporate profit forecasts affect analysts' estimates and stock ratings can help you make investment decisions.

- PRACTICAL PORTFOLIO BY DAVID MILSTEAD

EARNINGS season, those quarterly corporate financial reporting periods, can bring a lot of surprises—sometimes unexpected ones. In late October, for instance, General Motors reported a 50% drop in profits compared with the same quarter the year before. After the announcement, GM stock rose nearly 15%. That same day, Netflix reported a nearly 8% climb in profits. Its shares plummeted 10% on the news.

What gives? In both cases, what mattered most wasn't whether profits were rising or falling, but how the company's results compared with Wall Street's expectations, which are largely dictated by guidance from the company. Netflix's recent quarterly earnings, for instance, fell short of analysts' expectations; GM's came in ahead.

Company earnings-and-revenue guidance is essentially a forecast from corporate executives about how the firm will likely perform for the coming year or quarter ahead. Although the guidance isn't required, many large firms provide it. These corporate projections matter because they help shape the estimates and recommendations of Wall Street analysts—and that can sway whether investors buy or sell a given stock. What's more, over the short term, whether a company's actual financial results come in above or below analysts' estimates can move the share price, too, sometimes dramatically. All told, an understanding of the nuances of the corporate guidance game can be a useful tool for investors.

An evolving practice. The relationship between company guidance and Wall Street estimates is tight. The Securities and Exchange Commission first required public companies to report their financial results four times a year in 1970. With quarterly earnings reports came quarterly estimates from Wall Street analysts.