A Practical Guide to IPOs Chapter 8 – The Expectations Game

KEY LESSON: Under-promise, over-deliver. And be smart about the model you give out

Every 90 days public companies report quarterly earnings. For most companies, this will be the biggest news for the quarter and likely the biggest trading volume day for its stock. This generates a lot of anxiety and a lot of misunderstanding, but in reality the process is very simple.

Although companies publish complete results, 90% of investors will only look at four data points: 1) current quarter revenue; 2) current quarter earnings per share (EPS); guidance for 3) next quarter’s revenue; and 4) next quarter’s EPS.

Investors will compare those four data points to ‘expectations’ and make big decisions based largely on those numbers. These ‘expectations’ are usually the consensus estimates published by First Call and other market data services. In turn, those consensus figures are compiled by surveying the sell-side analysts who cover the stock.

Management teams have to put in a lot of work preparing for each quarter – closing the books, settling up with auditors, writing an earnings script, and preparing for investor Q&A sessions. But the sad truth is that most investors only process those four data points. Even those who take in the rest of the data view everything else through the prism of those numbers.

The goal for management teams is straightforward – beat expectations. Companies that beat expectations on all four metrics tend to see their stocks go up. Stocks that miss all four metrics tend to see their stocks go down. With all the expected variations in between. In some cases, a few other metrics matter, Twitter investors for example have been watching usage figures a lot lately. But in all cases, these metrics are compared to some set of expectations held by investors.

All of this is incredibly important to newly public companies. When I was an analyst I used to advise companies that there are only two things companies have to do after going public – beat all expectations on their first earnings report as a public company, and beat all expectations on their second earnings as a public company. Beyond that, we can work things out, but miss either of those two and you can go straight to the last chapter of this book “5 Years in the Wilderness”.

As with most things in Life, these first two quarters matter because first impressions matter. Most management teams are completely unknown to public market investors. Maybe the investors met management on the roadshow, or maybe they just saw video presentation online. These earnings calls are a public stage on which management teams reach a wide audience. That audience of investors use this demonstration to measure management’s credibility.

Teams that forecast 90 days out and hit those numbers are seen to have a good understanding and a stable business. Teams that miss those quarters… well that just raises a lot of questions. Is the business bad? Inherently unstable? Not as good as promised? Does management understand their business? Who is driving the ship? For more seasoned companies, investors will already have opinions about the answers to those questions and a track record by which to judge. For newly public companies, investors assume the worst and move on to other stocks.

So meeting expectations is really important. The thing to remember in all this, the silver lining, is that newly public companies are the ones setting the expectations which they themselves then have to beat. At no other point in the company’s life will they have such a free hand in setting those expectations. Once they are public, any analyst covered by First Call will have a vote in setting consensus expectations. But prior to the IPO, management is the sole source of all information. During the Org meetings with analysts and on the roadshow, management gives out its financial model. These eventually become analyst models which then end up as consensus. (Note: There are some wrinkles around the timing of the IPO and the analysts’ first publication of estimates, but in the beginning consensus usually looks a loot like what management says about their model.)

Management teams need to remember any investor or analysts building a financial model is going to take every number given to them and then extrapolate it. If a company goes public in January and estimates 100 subscribers by year-end, then everyone is going to model they have 25 in the first quarter, and be disappointed when the number only comes in 18. So management teams need to think through what numbers they give out, and how to communicate them.

Wait. Didn’t I just say that only revenue and earnings matter? Yes, for most companies, but the beauty of the IPO process is that companies can choose where they want investors to focus. This is especially true for companies that are not yet profitable. Maybe the number is users, or subscribers or some very weird, non-standard profitability metric. Whatever. Choose a number that: 1) you think you can forecast consistently; and 2) bears some resemblance to your actual business. Companies on an IPO roadshow can craft their own expectations. But this opportunity does not last past the first day of trading.

By this point in this series, we are 8 chapters and about 10,000 words in. The most important message to take away from all of that is:

When you provide financial forecasts for your IPO, make sure that they are numbers you can beat.
As always, do not break the law. Do not violate accounting standards. Do not do anything that hurts your real business. Just be smart about the model.

This is Chapter 8 in “A Practical Guide to IPOs”. The series begins here, and Chapter 7 here.

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