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The Expectations Game

Page history last edited by Alex Backer, Ph.D. 15 years, 9 months ago

The power of accurate observation is commonly called cynicism by those who have not got it.

--George Bernard Shaw



The cover of the Business section of today's L.A. Times boasts an article on the game played by studio executives and filmmakers to play down expectations on their films' opening weekend grosses, given that their success is judged not by whether their films make money or not, and not on whether filmgoers like their movie or not, but rather on whether the opening weekend grosses beat financial forecasts or not. This causes films with much larger grosses than others to be considered 'failures' while lower-performing ones are considered successes just because analysts' predictions were lower than reality.


The game is not confined to Hollywood. What makes the game even more ludicrous in boardrooms of private companies all across America is that, in these, the role of the analyst is played by the same actor as that of the filmmaker. Every quarter, CEOs across America try to beat the profit and revenue plans that, uhm, they themselves had set for the company. What ensues is rather predictable: CEOs dramatically underplay expectations and dramatically overemphasize risks. One consequence is that the 'plans' that Boards of Directors nominally use to judge a CEO's performance are useless. Worse, companies are governed in a way that overplays rather minimal risks, straying them from the best course for most likely scenarios.



Directors are no strangers to this game. Some ignore projections altogether. But for the most part, they play along. Seasoned venture capitalists say that a "good CEO" will lower everybody's expectations. How low, you ask? I have seen a CEO promote a new and "better" plan by predicting zero revenue growth for the duration of his forecast and plan. Plan for no new paying customers and modest "non-paying customer" growth even while spending more money acquiring each customer than the lifetime value of each.



Why do Boards of Directors play along? It's only human nature to notice only deviations from expectations. That's what the brain is all about.


Is this game in the best interest of the company? Not really.



Is there a better way? One alternative would be to have a third party do the projections, as is done with public companies. That's still not perfect, because the expectation of good or bad execution that comes with a CEO's track record is taken into account by analysts. But at least the problem of misaligned incentives (between a company's incentive for aggressive plans and reasonable metrics of success, and a CEO's incentive for pessimistic projections) would be solved. Another alternative would be for CEOs to be evaluated based on growth relative to the past, not on how they are doing relative to the projections they concocted themselves. That's what I do when I serve on a Board. Surely I'm not the only one. As John Lennon wrote, perhaps one day you will join us.



Cartoon copyright of the artist; property of CSL Cartoon Stock.

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