The Accuracy and Importance of Growth Guidance
How growth predictions and growth surprises translate to equity returns
By: Naoki Ito
The value of a company is the net present value of future cash flows. If we assume the discount rate for each company is incorporated in its current valuation ratio, then an accurate prediction of future growth would appear to be the single most important ingredient to successful corporate valuation. And, logically, we should ideally try to invest in companies with both high discount rates and high future growth.
Japan provides a wonderful testing ground for this simple hypothesis of betting on future growth. Almost all public companies in Japan provide full fiscal year forward guidance on revenue, operating income, and net income, so we can look each year at how accurate the predictions are and whether they’re useful, paired with valuation ratios, in predicting returns.
We looked at the last 20 years of data for all Japanese companies with fiscal years ending in March, and we compared growth guidance to realized growth and to realized returns. Realized growth rates were calculated as the year-over-year change in earnings. Growth guidance rates were similarly calculated but used forward guidance levels to estimate future earnings growth.
As a baseline, it’s important to note that realized growth does indeed correlate with equity returns, though the linkage is noisy. A simple regression of 1-year forward return on 1-year forward realized growth yields a coefficient of 0.2 with a t-statistic of 25. As expected, perfect foresight into future earnings growth would provide reliable information toward predicting future returns. However, the R-squared is only 5%, leaving around 95% of the variation in equity returns unexplained by earnings growth. There is still tremendous uncertainty involved in forecasting individual stock returns—even if we assume clairvoyance in knowing future earnings growth.
So how accurate are Japanese management teams in predicting future earnings growth? To answer this question, we regressed realized EBIT growth against the guidance forecasts for EBIT growth over the same fiscal year. This measures the accuracy of management’s guidance relative to the actual earnings outcomes.
Overall, the evidence suggests that guidance serves its purpose. It provides a good directional guide to the actual EBIT growth that will be realized over the course of a fiscal year. As shown in the figure below, the coefficient on guidance has a t-statistic of 65, indicating that guidance is a very reliable predictor of actual EBIT growth.
Figure 1: Regression of Realized Growth vs. Guidance (FY 2003 – FY 2023)
Source: Verdad analysis, Capital IQ
The coefficient (beta) on guidance has a value of 1.4, suggesting that, on average, realized EBIT growth is bigger in magnitude than the corresponding guidance provided by management. This applies to both positive and negative outcomes, as shown in the chart below. When guidance and realized growth are both ranked by percentiles, we see that the range of outcomes is wider for realized growth compared to guidance. This suggests that management teams may publish growth forecasts they hope to beat when good news is expected, and they may be slow to communicate the extent of bad news when earnings declines are expected.
Figure 2: Percentile Ranges for Guidance and Realized EBIT Growth (FY 2003 – FY 2023)
Source: Verdad analysis, Capital IQ
Even though guidance systematically underestimates the magnitude of actual growth by a factor of 1.4 on average, we wouldn’t get anywhere close to perfect growth forecasts by simply multiplying every guidance number by 1.4. This can be seen by the fact that the R-squared of the regression in Figure 1 is 16%, suggesting that 84% of the variation in actual EBIT growth remains unexplained, even after we account for the beta of 1.4 between guided and realized growth. Simply put, there are a lot of surprises in realized earnings growth, and these surprises are unknown even to company insiders who have the ability to influence the trajectory of their firm’s earnings.
If we sort realized and predicted earnings growth into three buckets—“low,” “medium,” and “high”—we find that Japanese companies are around 50% accurate in predicting which bucket their earnings growth will fall into.
Figure 3: Predicted vs. Actual Growth Rates, % Hit Rate
Source: Verdad analysis, Capital IQ
But here’s where things start to get interesting. The market harshly penalizes companies that project high growth but realize low growth (average return: -5%). Conversely, the market handsomely rewards companies with low growth projections that achieve high growth (average return: +27%).
Figure 4: Equity Returns by Bucket of Predicted vs. Actual Growth
Source: Verdad analysis, Capital IQ
It turns out, the hit rates are low enough on getting growth predictions right—and the market’s reaction to the upside and downside is so significant when predictions are wrong—that growth predictions don’t effectively predict stock returns at all. Regressing one-year forward return on one-year forward growth guidance yields an insignificant coefficient with an R-squared of 0%. The table below shows how this is true: we multiply hit rates by returns to see the cross-product of each category, which we can then sum horizontally to see average returns for each bucket of growth guidance.
Figure 5: Cross-Product of Hit Rate and Average 12M FWD Return
Source: Verdad Analysis, Capital IQ
The average forward one-year returns for companies in years when they guided for high, medium, and low growth were 11%, 12%, and 10%, respectively, showing no meaningful difference across projections.
Our favorite motto is that investing is not a game of analysis; it’s a game of meta-analysis. Stock prices already reflect growth projections. In our opinion, what drives returns is the deviation between projected growth and realized growth. While growth is indeed linked to returns in hindsight, growth projections alone do not translate into absolute returns. To earn high returns, you need an edge in identifying high-growth companies among those with low expectations and low-growth companies among those with high expectations. In fact, the data suggests that companies with low growth projections may offer downside volatility protection. Since low returns are already expected, there’s less room for negative surprises, making these companies potentially attractive for risk-averse investors.
So, does guidance guide us? It can help investors in terms of forward growth expectations but not with predicting returns. To succeed in investing, you must focus not just on what is projected but on what the market has yet to price in. We believe this distinction is where true opportunity lies.