The game has changed. The internet-driven, growth-frenzied circus has been replaced by the relative safety and logic of value investing. And just when attention refocused on the fundamentals, questionable accounting and reporting practices by the likes of Enron, Global Crossing, Waste Management, Xerox and Cendant have everyone concerned about the effectiveness of our Gaap-centric financial reporting system – and the honesty of those in charge of reporting results on that basis.
Investors are playing valueball, yet most companies continue to serve up the same old menu of quarter-over-quarter EPS. It’s not that earnings are unimportant, but this is the IR equivalent of showing up to play tennis with a golf club in your hand.
In this game you have two hurdles to clear if you are to communicate your financial results and prospects effectively. The first is convincing your audience that your application of Gaap is fair and reasonable. Even the exalted blue-chip reputation of GE came under suspicion as people began to wonder how its earnings growth had been engineered to be so smooth. Everyone’s calling for reforms to accounting standards and practices. Regardless, the first-task approach is to convince your constituency that you are playing fairly by these existing rules.
Here comes the next hurdle. The reporting produced by current accounting rules serves the information needs of the value investor about as well as the US tax code serves the interests of the nation’s taxpayers. Value investors invest in the business economics underlying the accounting. It’s up to you to tell your value story, and you have as good a chance of losing credibility here as you do explaining your accounting practices. Therefore, developing a clear and truthful message is key.
Vet the value plan
Every company has a value-creation story to tell, no matter what its current performance. Financially, it’s a story about prospective changes in rates of return and growth. It doesn’t necessarily mean you have to get bigger. Operationally, it’s about the core competencies and relative advantages that comprise your value-drivers. There are many examples of companies from most industries that have underperformed for shareholders during periods of significant growth and outperformed during periods of retraction accompanied by improved operating rates of return. A good example is IBM. During most of the 1980s Big Blue grew its assets at rates above its sustainable growth rate while cash economic returns fell; it was only when the asset base was reduced and rates of return were improved, beginning in the early 1990s, that the shareholders were rewarded.
Communication of the value plan does not always have to be complex. Just think of it as telling investors where you are economically, and letting them know where you plan to go. Call it the value vector. There are four basic types.
1 If your focus is simply on growing a business that has a positive spread, you are pursuing a quantity vector.
2 If your business needs to improve its rate of return before pursuing growth, or you are shrinking the size of the investment in the business, you are on a quality vector.
3 If you are taking on new projects which are expected to produce lower rates of return than the aggregate yet keep overall returns above the cost of capital, you are on an optimizing vector.
4 If you are growing your business with rates of return below the cost of capital hoping to achieve economic returns in the future, you are on a start-up or turnaround vector. You believe that scale economies or other expected synergies warrant the incremental investment, so you should tell investors what they are and when they will take hold.
Tell the truth
Spin is out and truth is in. Most years 20-30 percent of US public companies have sub-economic returns. Research by McKinsey this year found that half of US retailers fail to earn their cost of capital, while focusing on growth. Smart investors know it, and might be encouraged by corporate communication that recognizes the reality and addresses plans to create value from that position. Every company has a positive story to tell if they are willing to be truthful.
So as you set out to prepare your earnings announcement, don’t lose credibility with value investors through the sin of omission. Earnings are not cash flow. Moreover, no-one can tell if an increase or decrease in earnings or cash operating flow is good or bad without knowing how the invested capital base has changed. And from the investor’s perspective, the amount of investment in your business is not the depreciated book value produced by your accounting efforts. The market is playing valueball, are you?
Michael Choniski is a value development consultant who can be reached at +1 203 740 8545 or [email protected]
