Executives who feel their company’s shares are undervalued should seriously consider whether it’s because of a lack of relevant information. For example, disclosing and adequately describing the real value drivers will allow customers, shareholders and potential investors to make the right decisions about companies.
Merely thinking about transparency in financial reporting strikes fear into the heart of many a CEO. After all, public revelations call up the bugaboos of accountability and competitive exposure. But that is yesterday’s thinking. In today’s marketplace, greater transparency and better disclosure are keys in curbing the wild fluctuations and volatility of the world’s stock markets, and ultimately, in increasing shareholder value.
But there are certain things wrong with today’s financial reporting. Instead of traditional financial statements prepared under generally accepted accounting principles, with independent audit reviews for accuracy and compliance with accounting standards, we now have a myriad of forward-looking and interpretive information without consistency of format and often, objectivity. What’s more, traditional corporate reporting practices don’t capture relevant market information and the non-financial measures that drive value. Today, financial reporting represents a shrinking percentage of the information that the market considers important. In fact, the flow of information has become entertainment with shows and networks devoted to “the market.” From early morning to late evening there is a constant flow of information that, regardless of its reliability, can greatly affect the short-term fortunes of a particular company or market segment.
The case for Value Reporting
If traditional accounting and reporting models are inadequate in providing a full picture of corporate health, then companies need to shift the focus of their reporting. They need to supplement historic financial information with more information about value-building activities and non-financial measures. The big challenge for every company is the development of reliable and valid measurement methodologies for value-relevant, nonfinancial performance measures that have predictive value – measures that are an indication of how much shareholder value will be generated in the future. The Value-Reporting model is about broadening corporate reporting to have companies identify and meet analysts’ and investors’ needs for relevant information about value drivers, intangible assets and estimated future cash flows. Many companies have already started in this direction with new internal metrics. The use of the Balanced Scorecard approach, for example, is a step in the right direction but it is only a first step. A great deal more is required. The reality is that relatively little has been done to systematically address either the need or the process for providing information the market wants and needs to know.
The problem is that investors can’t value what they don’t know. They don’t have the information to see the business as management sees it. They don’t see the value of R & D, brand names, market share, employee satisfaction, customer retention and the intellectual capital of the business. Although companies generally do have a wealth of non-financial data that identifies and supports value, value reporting is not as straightforward as financial reporting. Whereas it’s easy to report earnings-per-share, it’s more difficult to crisply and objectively report value drivers like customer satisfaction, brand recognition and market share. The good news is that analysts, investors and corporate executives agree about the kinds of information that the market needs to accurately value companies, although the order of importance varies somewhat.
Each industry has different business drivers that help drive value creation. For example, the top ten list of relevant value drivers in the high-tech industry includes just three financial measures: earnings, cash flow and gross margins. Of the nonfinancial factors, three measures, strategic direction, quality/experience of the management team and speed to market, come from internal company data. The final four factors, competitive landscape, market size, market growth and market share require data that are not typically captured by internal systems.
Specific industry drivers might also involve capacity-utilisation such as rooms-occupied in the hotel or cruise ship industry, or seats-occupied on airlines and at entertainment events. They may involve productivity metrics in the professional services industry such as number of charged hours or rate per charged hour. While each industry tends to have specific drivers, each company within the industry may emphasize and focus differently on these value drivers.
A clear picture
If investors and the market are to properly value a company, they must understand the key value drivers the company has identified, the targets it has set, the actions taken and the results achieved. This involves a great deal more transparency in the flow of information about internal metrics and value drivers. Many executives are concerned about revealing this information, often citing confidentiality. They also don’t want strategic information in their competitors’ hands or they are afraid to publicly set income targets and be held accountable. But if information is going to be used internally for company-wide strategy, competitors will invariably find out. And a company is more apt to be successful in achieving its goals if the goals are made public, as this helps focus the organization on the company’s key objectives and the importance of meeting public expectations.
Without broader value drivers, we are stuck with the “Earnings Game.” This is a game played in the press and by the sell-side analysts, whose main focus is on a company’s short-term performance and its reported earnings. The Earnings Game has turned earnings reporting into a complicated balancing act that is played out daily in the press and on television. It starts with analysts trying to predict a company’s quarterly earnings. They do this based on information gathered from a given company and by adding their own economic and market assumptions. The playing field for information gathered from a company has recently been levelled by the SEC’s Regulation Fair Disclosure, which requires companies to make material information available to everyone at the same time. In Canada, the proposed National Policy 51-201 Disclosure Standards focus on fair disclosure. However, Canadian insider trading and tipping rules, which prohibit all selective disclosures other than those made in the necessary course of business, already address the issue.
In the Earnings Game, the company tries to manipulate the market through the management of earnings expectations, while the street develops a consensus expectation. The pressure is on companies to participate in this exercise for fear of a negative reaction to a surprise with earnings that are slightly below expectations. With the move away from historic financial information under the generally accepted accounting principles umbrella, a whole new series of company, street and press-related earnings approaches have sprung up. There are the “earnings before” (EB) which can range from earnings before goodwill (EBG), to earnings before interest, taxes, depreciation and amortization (EBITDA). There are the earnings that disregard particular non-recurring items, and there are pro-forma earnings. There are a variety of cash flow numbers before or after certain items. Comparability between companies’ earnings as reported in the press can differ considerably depending on what earnings are being referred to.
The “Earnings Game” toll
The street can punish a negative earning surprise. As a result, management is forced into managing expectations and into managing its results for short-term impact. Executives have, on occasion, employed suspect accounting practices in order to meet or exceed expectations. In addition, there is a constant market demand for consistent quarterly earnings growth. E v e n Companies who manage to deliver consistent results and manage expectations can find themselves part of the “whisper number” or “real” earnings forecast that start a new round of managing expectations and results. Both the company and its investors suffer as a result of such practices. Investors’ value is being affected by wide price swings not from the real intrinsic value of their investments but from the street punishing a surprise. One need only look at the wild fluctuation in certain stocks over the past few years, when quarterly estimates came in a penny lower or higher than the street’s expectation. This does not assist in a rational allocation of capital.
Too many executives find themselves locked into this never-ending and highly dysfunctional game. Management requires considerable time and energy to manage street expectations. A CFO Magazine survey found that three out of five CFO’s spend more than 10 percent of their time dealing with analysts, while two out of five gave more than 20 percent of their time to dealing with analysts. Short-term results become more important than long-term results. In this world, private companies that do not have to play this Earnings Game may have competitive advantage over public companies that are forced to play it.
Management, analysts and investors continue to play the Earnings Game despite the fact that earnings are focused on past rather than future performance and are becoming less important in determining the value of a company. Historic earnings have become a bottom-line figure for value, which may be totally unreliable in anticipating a company’s true worth. But still, managers focus on the short-term goals of optimising current earnings to meet current expectations, sometimes sacrificing the long-term interest of the company and its constituencies. As a case in point, the compensation model for many senior executives is biased towards short-term performance in the Earnings Game, in order to maximize the value of their stock based compensation plans.
Such a short-sighted focus ignores the need for, and value of, future strategies, and forces executives to sacrifice long-term valuation opportunities to satisfy short-term demands. The best solution for ending the Earnings Game is to cut-off its food supply. To do this, progressive companies must report earnings, as well as additional financial data, more frequently. Reports on a monthly, weekly or even daily basis can stop the obsession with estimated earnings expectation and provide a consistently clear outlook on a company’s value. By reducing the attention they give to short-term earnings and cash flow, investors and analysts would be able to focus on other financial and non-financial data in their assessment of a company’s true value. Such an approach may lack the theatrics of the Earnings Game, but it would make for a more accurate assessment of a company.
A framework for effective corporate reporting
What information should a company gather and report? A framework for effective corporate reporting has four main elements:
Market Overview – provides management’s take on the company’s external market. Although no one can predict the future, investors want to know what the company’s leadership thinks the future holds. This should typically include the competitive environment, the regulatory environment and macroeconomic environment in which the company operates.
Value Strategy – explains in detail how the company will compete in its marketplace, and outlines its strengths and weaknesses, goals, objectives, governance and management.
Managing for Value – reports on financial performance and position benchmarked against competitors and peers, risk management, and segment results.
Value Platform – details how well a company manages its tangible and intangible assets, including innovation, brands, customers, supply chain, people and social and environmental reputation, to create value.
In developing measurement methodologies, a company must focus on its unique industry metrics and concentrate on those that best fit the company’s strategy. Although many industry groups are working independently in this area, there is a great deal of work to be done in establishing non-financial metrics by industry and general standards around the development and calculation of such metrics. The Canadian Institute of Chartered Accountants is leading a global initiative to try and develop global standards for value creation drivers. It is working with other major accounting bodies and the large global accounting firms to identify the key value drivers and risks and to set global standards to assess and compare them. The accounting profession, with its global reach, must play a critical role in bringing about these changes in external reporting.
Getting the word to the street
Delivering the information is as important as defining what information is to be delivered. In addition to the Earnings Game’s ability to distort the allocation of capital, there is also the issue of a high degree of concentration in market value on global stock exchanges, which distorts the allocation of analyst, media and investor attention. For example, at September 30, 2001, the top 15 companies listed on the Toronto Stock Exchange accounted for less than one percent of the total listings. Yet these same companies accounted for 41 percent of the exchange’s value. (This is down from February 2000 when the top 10 accounted for 41 percent of the exchange’s value.) Similar concentration occurs on other major world exchanges. Typically, the top companies have significantly higher P/E ratios than their exchange’s average. While this can be partially explained by brand names, higher growth rates for the market value leaders and perceived lower risk, there is also an information gap. The larger companies have a broader audience, attracting more analysts, press coverage and investors, which all boost relative stock prices. The fight for airtime becomes more difficult for the rest of the market. The visibility of the large cap companies enables them to get their stories out more readily and easily than smaller cap companies. In addition, the visibility of the large cap companies requires more market communication.
For the majority of companies who are not amongst the chosen few, there is a need to bridge the communications gap. There are five identifiable gaps in getting their word to the street:
The Information Gap. The difference between the importance that analysts and investors attach to a value measure and how satisfied they are that their information needs in regards to that measure are being met by company managers.
The Reporting Gap. The difference between the importance that managers attach to a value measure and how actively they work to report on it.
The Quality Gap. The difference between the importance that managers attach to a value measure and the reliability of the information provided by their internal systems.
The Understanding Gap. The difference between the importance that managers attach to a value measure and the importance that analysts and investors attach to it.
The Perception Gap. The difference between how actively managers think they work to report on a value measure and how analysts and investors perceive the adequacy of the information they get on it.
In order to increase their visibility, companies need to start addressing their circumstances relative to these five communication gaps. They need to recognise where a gap exists and to address the need.
The lack of effective communications and the current failure of companies to report non-financial information place them in peril. Executives who feel their company’s shares are undervalued should seriously consider whether it’s because of a lack of relevant information. Is the company being transparent enough with its critical value drivers? Customers, shareholders and potential investors will make decisions about companies whether they use accurate data or not. If companies don’t provide information, someone else with suspect reliability may, with resulting damage to a company’s stock.
Value-Reporting requires a real change from corporate executives and boards of directors, charging them with the responsibility of ensuring that all material information about the company is disseminated as quickly as possible to all interested parties simultaneously. Companies must develop sound measurement methodologies for the key non-financial drivers and intangible assets that the market finds most important. They must communicate the resulting information in an organized and structured way. In the end, we must move away from the Earnings Game to an environment in which the value drivers are visible. Once we do that, we will be able to improve the allocation of capital and our ultimate economic health.