Why an upbeat forecast based on customer satisfaction backfires

Investors can readily discount managerial optimism and react negatively

The link between customer satisfaction and profits for a company may appear self-evident at first glance. If customers are satisfied with a company’s products or services, they are likely to return and buy more, thus improving the company’s profits.

And while that link does indeed hold true, there has been little research on how a positive customer satisfaction rating affects a managers’ communications with investors, and in turn, how investors react.

In a new paper, Does customer satisfaction matter to managers’ earnings forecasts and stock returns?, UNSW Business School lecturers Jenny (Jiyeon) Lee and Youngdeok Lim, along with Hyung Il Oh from the Bothell School of Business, look at how customer satisfaction data affects management earnings forecasts.

For the study, published in the European Journal of Marketing, the researchers took a sample of US firms that released both a voluntary management earnings forecast and their American Customer Satisfaction Index (ACSI) ratings between 2001 and 2010.

The ACSI measures the satisfaction of 250,000 US household consumers with the quality of products and services offered by both foreign and domestic firms with significant share in US markets. 

It aims to benefit business, researchers, policymakers, and consumers alike by serving as a national indicator of the health of the US economy, as well as a tool for gauging the competitiveness of individual firms and predicting future profitability.

‘Managers cannot get overly positive market reaction from the optimistic management forecast’

YOUNGDEOK LIM

Optimism bias

The researchers first looked at whether a firm’s positive customer satisfaction rating affected the likelihood that management would issue earnings forecasts and, second, how it would affect the forecasts.

They found that managers were indeed more likely to issue voluntary forecasts because positive satisfaction ratings lead them to anticipate increased future cash flows.

The finding is in line with prior studies that observed when earnings are rising companies disclose their earnings forecasts more frequently, and that the frequency declines when earnings are declining.

Furthermore, Lim and his co-researchers found that managers of firms with high customer satisfaction ratings were more prone to issuing optimistic forecasts. 

Lim, a senior lecturer in the school of accounting at UNSW Business School, explains that strong customer satisfaction ratings are more likely to lead to an optimism bias – that is, managers are more likely to overestimate earnings.

The work builds on previous studies into earnings forecasts made by overly confident managers, which found that not only are confident managers more optimistic about their firm’s future profits, they also discount the probability of unexpected events such as fluctuations in the business cycle, given their belief that positive satisfaction ratings lead to future cash flows.

Negative reaction

The researchers next looked at how investors reacted to earnings forecasts that were based on positive customer satisfaction ratings. 

They drew on previous research suggesting that share market participants are aware of (over)confident managers’ predisposition to make irrational decisions based on their overestimated ability and overly optimistic outlook on returns, and respond accordingly.

By examining stock price movements of firms in the days after managers made an optimistic earnings forecast based on positive customer satisfaction, Lim and his co-researchers concluded that the forecasts had significant negative effects on share prices.

“Investors may discount the optimism of earnings forecasts issued by managers who are confident and optimistic of their ability to generate future cash flows upon learning of the firm’s high satisfaction ratings,” the researchers write.

Lim says managers should understand the link between customer satisfaction ratings and excessive optimism and how investors react. 

“They also need to understand that investors can identify this – the optimistic buyers component – and they can react to this negatively which means the managers cannot get overly positive market reaction from the optimistic management forecast,” he says.

Meet or overshoot

Russell Wright, head of research at investment firm EverBlu Capital and the winner of the Australian Stockbrokers Researcher of the Year award in 2017, says that as an equity analyst he doesn’t take any notice of customer satisfaction ratings.

“It’s too far removed as a driver of the share price. It’s not something that even constitutes input into the databases for which we have massive amounts of data on each company. It’s not even recorded,” Wright says.

Nonetheless, he does take notice of management earnings forecasts when assessing a stock and says analysts get to know which companies are more likely to issue conservative guidance, which they will meet or overshoot, and which are more likely to issue overly optimistic guidance.

However, he says he seldom sees companies issue overly optimistic forecasts because their credibility is at stake.

According to Wright, stocks may rise 4% or 5% thanks to a positive forecast, but if a company fails to meet its earnings forecast, the share price can fall as much as 50%.

Lim says while looking at customer satisfaction ratings would be new for many analysts, the research would be of assistance to them when they look at management earnings forecasts, knowing how customer satisfaction reports may have affected them.

‘It’s too far removed as a driver of the share price. It’s not something that even constitutes input into the databases’

RUSSELL WRIGHT

Better decisions

The researchers note that while customer satisfaction is typically used as a management control system for monitoring future performance, and implementing marketing strategies and allocating resources toward improving customer services, their study is the first to examine whether customer satisfaction is also related to the issuance and optimism of managers’ earnings forecasts. 

Second, the study complements the existing marketing and accounting/finance research into how investors and analysts perceive customer satisfaction ratings by also looking at how the ratings are used by management in their financial forecasts.

“There appears to have been little discussion on how satisfaction information leads to managers’ forecasts of future earnings and the resultant business performance in the literature,” the researchers write. 

“Therefore, the study results highlight the role of managers in the relationship between customer satisfaction and firm value.”

As for practical application: “The study results indicating the relevance of customer satisfaction to management earnings forecasts not only shed light on the justification of marketing expenditures but also provide a response to the call for marketing accountability. 

“The study results also enable managers to make better decisions about whether and when to issue a forecast, which has been lacking in the management earnings forecast literature,” the researchers write.

https://www.emeraldinsight.com/doi/abs/10.1108/EJM-06-2017-0422