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Feb. 11, 2004. 01:00 AM
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Focus on profit targets costly, study says
Many companies scramble to meet analysts' forecasts

Improving value longer term often takes second place


Publicly traded companies in Canada and the United States are making business decisions that will undermine their long-term value in order to meet short-term earnings targets, says a study by researchers at Duke University and the University of Washington.

The study found that intense pressure from Wall Street and Bay Street analysts to meet earnings estimates is causing senior managers at some companies to sacrifice spending on long-term goals such as research and development in order to meet quarterly earnings targets.

"Because of the severe market reaction to missing an earnings target, we find that firms are willing to sacrifice economic value in order to meet a short-run earnings target," says the study released this week by authors Campbell R. Harvey, John R. Graham and Shiva Rajgopal.

"Missing an earnings target or reporting volatile earnings is thought to reduce the predictability of earnings, which in turn reduces stock price because investors and analysts hate uncertainty."

The aversion to missing a target is so strong that 78 per cent of respondents said they would give up economic value for smooth earnings.

More than half the companies surveyed said they would delay starting a project just to meet an earnings target, even if they believed the project would eventually be profitable. And 80 per cent said they would cut spending on research, advertising or maintenance, which would not hurt in the short run but could over time.

"It shows clearly that decisions are being made for the short term," said Harvey, a professor of international business at the Fuqua School of Business at Duke University in Durham, N.C., and a director of Torstar Corp., parent company of the Toronto Star.

"In the big picture, this hurts the corporate position of Canada and the United States. If you're not making the right long-term business decisions, then down the road you will see a loss of jobs, and eventually an erosion in the gross domestic product of your country."

The survey of 401 financial executives across North America was done in late 2003 by mail and e-mail. Another 20 executives were questioned in person or by phone. Many of the executives were from large Fortune 500 companies in Canada and the United States, said Harvey.

"They were amazingly blunt about the issue," said Harvey. "There is certainly a sense that they didn't like to play the game, but they are being forced to play the game, otherwise there could be all sorts of consequences, including losing their job."

It is not unusual to see severe stock market reactions to a company that misses its earnings target, says the study.

"Not being able to find one or two cents to hit the target may be interpreted as evidence of hidden problems at the firm. Additionally if the firm had guided analysts to the earnings-per-share target, then missing the target can indicate that a firm is managed poorly in the sense that it cannot accurately predict its own future."

Unlike the accounting scandals of the last two years that have pummelled the corporate world, this is a much "deeper and more subtle" issue that affects everyone, said Harvey.

"Most of the focus right now is on weeding out the gross misdeeds of corporations. But now we have clear and irrefutable evidence of another problem that is deeper and more widespread," he said.

When he first started to put together the survey, Harvey said, he did not expect the kind of results he ended up with.

"I think in a way it was a crying out — a hope that their voices would be heard," he said.

Harvey said to get companies to focus beyond the quarterly results, investors will ultimately have to demand change.

Additional articles by Tony Wong

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