An Examination of Individual Customers’ Use of Earnings Benchmarks

Abstract

While an extensive body of prior empirical research documents that a firm’s ability to meet relevant earnings benchmarks is important to equity and debt investors, there is little evidence on whether meeting earnings benchmarks is important to non-investor stakeholders as theory suggests. This study examines this issue, focusing on customers. Using both levels and changes analyses on a proprietary dataset of customers’ perception scores, we find that individual customers’ perceptions are positively associated with a firm’s ability to beat the profit benchmark. This finding suggests that, just as creditors use the profit benchmark to infer a firm’s ability to meet its long-term financial obligations, customers rely on the profit benchmark to infer a firm’s ability to fulfill its implied future obligations on products or services. Consistent with this interpretation, the positive association between the profit benchmark and customer perceptions is heightened for firms in durable goods industries where such obligations are most significant. Unlike investors, customers significantly downgrade their perceptions once a firm exceeds the profit benchmark by a wide margin, suggesting that customers may question a firm’s business practices when its profits appear to be excessive. We further find that beating the profit benchmark is more important to customer perceptions of firms in the introduction or decline life cycle stages and of firms with high default risk. On the other hand, beating the profit benchmark is less important to customers when firms exhibit superior non-financial performance based on widely publicized ratings of product quality, corporate reputation, and corporate social responsibility. These findings highlight the contextual nature of customers’ reliance on the profit benchmark. This study provides the first empirical evidence on the theoretical prediction that non-investor stakeholders rely on relevant earnings benchmarks to evaluate firms.