On the surface, it seems to be business as usual at the US Financial Accounting Standards Board (Fasb), an institution whose very name conjures up predictably bland images of pocket protectors and calculators. But to anyone who has a stake in the process of valuing companies – and in these days of global communication, that equates to just about anyone with an internet connection and a brokerage account – the number crunchers at Fasb have been stirring up a hornet’s nest of interest.
The controversy centers on an old debate that pits the proponents of cash flow against those who favor earnings as the most reliable barometer of corporate performance. Focusing on cash flow-type measures, so the argument goes, provides for a substantially more accurate picture of performance that is less susceptible to manipulation. It allows analysts to remove unique, short-term anomalies, which can drag down and distort earnings. Others, however, maintain that companies that do not want to be judged on their earnings simply want to avoid admitting that they have no earnings.
Fasb has been tinkering with one of the key components of the corporate reporting process: goodwill. Goodwill is the premium paid for a company above its book value. In April, the board voted to eliminate ‘pooling of interests,’ an accounting tool for handling corporate mergers, with effect from January 2001. At present, pooling of interests accounting enables merging companies to simply combine the two balance sheets, thus allowing them to avoid the charges that goodwill attracts. The move was widely viewed as a painful body blow to acquisitive companies, particularly those in the technology sector, whose earnings look set to be significantly reduced by the increased charges.
Hard on the heels of the controversial pooling of interests decision, Fasb then voted in May to reduce the maximum write-off period for goodwill from 40 years to 20 years, adding stinging insult to injury for those companies that had been hoping for a more serious consolation for the loss of pooling of interests accounting. Finally, in a vote in which two board members dissented, Fasb board members voted in June to require acquisition costs to continue to be charged against operating income.
By way of damage limitation, Fasb did go on to say that it would allow goodwill charges to be listed separately from the other charges on a company’s financial statements before they are subtracted from operating earnings. However, the two dissenting members, as well as numerous other critics, argue that goodwill should actually be moved outside of income from operations completely, thereby making it easier for analysts to calculate cash flow-type numbers – and in particular, something known as cash earnings.
Rise of cash earnings
Cash earnings, or cash earnings per share, is a cash flow-type measure that adds back to operating earnings the amount that has been written off for amortization of goodwill. While cash earnings per share has been around for quite a while, the recent moves within Fasb have brought the measure far greater and wider attention. In April, the month in which Fasb voted to eliminate pooling of interests accounting, First Call Corporation announced that it intended to change the calculation method used for 20 internet companies, opting for cash earnings per share.
‘It is trying to come up with a number that gets the more unusual costs out of the way in a reasonable manner that is reflective of what is actually going on,’ says First Call’s director of research, Charles Hill. ‘Some of these non-cash things, that Fasb has within its rules, are noticeably distorting the numbers for valuation purposes. Should these things be recognized? Sure. But you don’t want them to be part of the company’s income statement.’
Hill believes that the prevalent trend among both analysts and companies is toward a measurement of performance that is based on cash flow as opposed to earnings. He goes on to point out that a markedly similar situation occurred with real estate investment trusts, which are now primarily measured on funds from operations, which is a cash flow-type measure.
‘For oil companies, earnings are still the primary evaluation tool, but cash flow is the tool right behind that, if not equal to it. For other industries, however, Ebitda or other cash flow-type measures are being used,’ says Hill.
First Call’s decision to release cash earnings per share numbers for internet companies simply reflects the growing trend toward cash flow based measures being utilized by analysts and other market participants. In a report issued by investment bank JP Morgan shortly before Fasb voted to eliminate pooling of interests accounting, Rick Escherich, managing director in JP Morgan’s mergers and acquisitions group, not only echoed this sentiment, but also predicted that Fasb’s decision would ‘accelerate the shift to cash flow based multiples, especially cash EPS, in valuing equities.’
‘My focus is, from a very simple PE approach, what is the next approach investors will take? Will there will be a move from PE to cash PE?’ says Escherich.
According to Escherich, over two-thirds of all industries are followed on some form of a cash flow basis, and a significant majority of US sell-side analysts now calculate a cash flow multiple for the firms that they are following. In surveying some 178 sell-side industry reports for its own report, JP Morgan has found that 72 percent of reports included a cash flow multiple.
Corporate reporting
Companies, too, are beginning to release their own cash-based results. According to the Wall Street Journal, RJR Nabisco Holdings, USA Networks, Bank Rhode Island, SLM Holding, Aurora Foods, Household International, Sovereign Bancorp and Carolina First Corp all disclose some form of cash-based earnings in reporting performance. JP Morgan identifies an additional 55 companies that, since July 1998, have reported cash EPS-type numbers.
Bill Leach, a research analyst at Donaldson Lufkin & Jenrette, thinks that the additional reporting on the part of companies is a useful addition. Leach follows Aurora Foods, which publishes a cash earnings per share figure. ‘It is a very acquisitive company,’ he says. ‘Aurora has a huge goodwill charge which is equivalent to 50 percent of their reported earnings, so I think you have to value the company on cash earnings per share. The goodwill charge is really distorting the EPS for these companies in the food industry.’
To Leach, the issue of goodwill is especially touchy due to the changing dynamics of the market and the recent moves by Fasb. ‘The paradox of goodwill, at least in my industry, is that if it’s 50 percent of your earnings, people are forced to add it back, but if it’s 20 percent of your earnings, no-one adds it backs, so you get no credit. The market is very confused right now on the issue,’ he says.
Global trends
In the UK and Europe, the use of cash-based measures for valuing companies is less common relative to the US, but the question of how to treat goodwill has incited an equally intense debate. As of 1998, companies in the UK must write off goodwill, including it in their income statements and incurring the hit to their earnings per share numbers. Whether or not this will prompt more companies to take advantage of pooling of interests accounting, or ‘merger accounting,’ as it’s known in the UK, remains to be seen.
In December 1998, the UK’s Accounting Standards Board (ASB) had proposed the elimination of pooling of interests accounting, and had issued a discussion paper on the proposal. ‘Based on the response to the discussion paper, we in the UK concluded that we do not want to amend our present standard, which allows merger accounting in certain restricted circumstances,’ says Michael Butcher, secretary of the ASB.
While Butcher declines to comment on the implications of the ASB decisions, others believe that more and more investors will add goodwill amortization back to the income statement and focus on cash flow measures of performance, though at a pace that’s less aggressive than that of the US. At present, the majority of companies in the UK still report non-cash earnings numbers with their results, and the analyst community tends to focus on non-cash earnings numbers.
‘I think that the UK is splitting into two camps,’ says Mike Corless, head of UK equities at Edinburgh-based Scottish Widows Investment Management. ‘Some UK companies are using value-based management and cash flow techniques to manage their businesses, and they are generally giving information to the investment community in that format. However, other companies are driven by earnings per share, because that is what they believe to be important.’
Corless considers that the UK investment community is currently split along the same lines, but he believes that cash flow measures are beginning to draw more interest. One of the reasons for the increased acceptance, he argues. has to do with the changing composition of the markets. As in the US, there are more and more companies for which cash-based tools are needed to achieve accurate valuation – in particular, technology companies, telecommunications and other high growth stocks, many of which are growing through acquisitions.
According to Corless, Scottish Widows has based its entire investment process around cash flow-based measures. ‘We have basically said that the traditional accounting-based methods do not work. We want to be able to get to the ongoing underlying cash flow from the business and determine how sustainable it is. From our point of view, we are finding that those companies that are using cash flow methods to run their businesses are generally outperforming.’
Although most UK companies aren’t offering up cash earnings-type figures, Corless notes that companies are providing analysts and investors with more information to facilitate the calculation of cash flow-type valuations. ‘More investors are looking for cash flow figures and more companies are giving information on those numbers. But we’re behind the US and continental Europe is behind us.’
Contemplating the future
The proponents of cash flow measures of performance agree that in order for a specific accounting measure to catch hold and become commonly accepted, some sort of standardization needs to take place. Whether it be cash earnings, Ebitda or some other measure, market participants must have the means to compare consistent numbers, and database companies such as First Call must be able to come up with consensus figures. At present, however, the manner in which analysts and companies derive their calculations are far too subjective and varied for this to happen.
‘Twenty years ago, you just could not compare earnings. They simply were not timely or accurate enough,’ says First Call’s Hill. ‘There was a real consensus problem so you couldn’t database the numbers. As First Call and our competitors got better data, people started focusing more on earnings. I think the same thing will happen when you have a consensus with some of these cash flow measures, such as cash earnings per share.’
Hill notes that analysts are pushing Fasb and others toward more of a cash flow-type number, and their pressure seems to be paying off. In June, Fasb announced it plans to allow companies to include cash earnings along with regular earnings per share. The change is expected to take effect in January 2001.
‘That goes a long way toward getting cash earnings universally accepted,’ says Robert Willens, a managing director and accounting expert at Lehman Brothers. ‘I think Fasb recognizes that they have to come up with something that’s acceptable.’
Just how far Fasb will go in meeting the demands of proponents of cash flow-type measures is unclear. In a surprising move, the board announced in mid-June that it would hold a public hearing in early 2000 on the elimination of pooling of interests accounting. Despite the concession, however, few people believe that the early vote to quash the pooling of interests method will be reversed, and even fewer doubt the debate over cash flow versus earnings will abate.
