Under pressure to hit immediate performance targets, many managers inflate earnings, often by cutting expenditures. In a recent survey of 401 top financial executives, 80 percent said they would decrease spending on “discretionary” activities like marketing and research and development to meet short-term goals.

But how discretionary can such spending be, given that cutbacks in these areas can have substantial negative effects on future performance? It’s true that this kind of shortsightedness may temporarily fool the stock market by giving the appearance of improved prospects.

However, in our study following the financial performance of 2,859 companies over five years, 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 percent four years out.

We focused on company and financial market behavior during and after seasoned equity offerings (when public firms issue additional stock) in the three decades from January 1970 to December 2001. 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.

To determine which SEO firms were most likely to engage in this sort of myopic management, we examined companies’ profits and SG&A (selling, general and administrative) spending—which has marketing and R&D as its primary components—around the time of their SEOs. During years in which SEOs were issued, we observed a 40-percent increase in the number of firms simultaneously reporting above-normal operating profits and below-normal SG&A expenditures (“normal” being what was expected given the industries’ economic conditions and the firms’ past performance). We grouped these firms into a “potentially myopic” portfolio and the other companies into a “nonmyopic” portfolio and then assessed the future risk-adjusted stock returns of the two groups.

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 (the difference between actual and expected 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 percent 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 percent.

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. For example, many of the key aspects of a brand’s strength, such as differentiation from the competition or the degree to which customers perceive the brand as relevant to their needs, can be measured through surveys and then linked to compensation. Long-term performance measures will motivate executives to manage with an eye to the future. 

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Natalie Mizik is an associate professor of business at Columbia Business School in New York. Robert Jacobson is a professor of marketing and transportation at the University of Washington Business School in Seattle. This article is based on their research study in the journal Marketing Science (May-June 2007).

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