Business Management Blog

Under pressure to hit immediate performance targets, many managers inflate earnings, often by cutting expenditures. In a recent survey of 401 top financial executives by Natalie Mizik and Robert Jacobson, 80% said they would decrease spending on “discretionary” activities like marketing and R&D to meet short term goals.

It’s true that this kind of shortsightedness may temporarily fool the stock market by giving the appearance of improved prospects. However, in their study, firms that appeared to make short-term expense adjustments to inflate earnings when they issued equity ended up losing profits in the long run, causing their market value to drop by more than 20% four years out.

Because the amount of capital collected by a firm depends on the stock price on the day the equity is issued, managers have an acute interest in that price and may be tempted to give it a quick boost by inflating earnings through cost cutting. After all, investors rely on current earnings measures when they form their expectations of future performance and, therefore, when they value equity.

Even though market participants realize that all companies have incentives to inflate earnings to increase their SEO proceeds, they cannot tell with certainty which ones are actually doing so. As a result, they tend to give less credence to all earnings reported at these times. But only after expense cuts result in inferior profits for individual companies do the consequences materialize in lower stock prices.

If the financial markets properly valued the management strategies implemented in the year a firm issued an SEO, that company’s share price would not be adjusted (either up or down) in subsequent years. This was essentially the case for firms in the nonmyopic portfolio -– the ones that didn’t simultaneously report a spike in profits and a dip in SG&A expenditures.

For those companies, abnormal stock returns were consistently level in the years following the SEO. That was not true, though, for the potentially myopic portfolio. This group initially fooled the market, realizing an average positive abnormal stock return of 15.7% the year an SEO was issued. The next year, however, cumulative returns dropped, and they continued to decline. By the fourth year after their SEOs, the group of potentially myopic companies had abysmally abnormal returns of –22.3%.

It’s clear that managing for the short term comes at the expense of firms’ long-term value. But what can be done to limit this type of behavior?

One reason that managers engage in myopic management is that they are evaluated on current financial performance. Often, managers are rewarded for the gains but not penalized for the losses, or they are able to move on before negative consequences transpire.

Companies can reduce incentives for myopic behavior by increasing vesting periods and delaying payoffs to departing executives. Firms should also look beyond their current earnings and share prices when setting performance evaluation standards. Consideration should be given to a variety of factors, both financial and nonfinancial.

The nonfinancial ones need to reflect strategies with long-term value implications. Long-term performance measures will motivate executives to manage with an eye to the future.

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