THE income statement is dead. Long live the income statement. Even before Enron’s collapse in 2001, investors had repeatedly discovered – to their cost – that highflying companies that generate spectacular increases in revenues and earnings in a relatively short space of time tend to emulate Icarus. Like the hero of the ancient Greek myth, they fly too close to the sun, the wax in their wings melts and they plummet to the corporate equivalent of death.
It seems completely counterintuitive. After all, if a share price is the multiple of the company’s earnings and its price:earnings ratio, then surely the higher the earnings, the higher the share price?
But over and over again we’ve seen corporates take honours in top company surveys based on increases in market capitalisation, revenue and earnings over short time horizons.
Winning these surveys often seems to be the kiss of death. Companies such as W&A, Profurn, Q-Data and Dimension Data have all won the Sunday Times annual best company ranking. Look at them now: the first three are now just memories, and multi-year winner Didata lost most of its market cap within a year of winning the award in 2000.
In a nutshell, all these companies have one thing in common: they grew revenues (and earnings) rapidly through acquisition and expansion programmes. But though all the income statements benefited – at least initially – shareholders paid for growth that had been bought at an unjustifiable price.
Simply, companies paid more for assets than they were worth because they didn’t pay attention to earning a higher return on their investment than their cost of capital. That would be similar to an individual borrowing from a bank at prime and then depositing this money in a call account, earning an interest rate below prime.
In the long term, share prices increase because companies create value – not earnings – for shareholders. And shareholder value is created by earning more than a company’s cost of capital.
That’s one of the reasons why investors are increasingly turning to a class of investment valuation tools known as “value-based metrics” and include models such as economic value added (EVA®) and cash flow return on investment (CFROI).
The second reason that value-based metrics are likely to become more popular is that they’ll interpret increasingly volatile income statements following the implementation of AC 133 and the changeover to International Financial Reporting Standards next year in a way that makes sense to investors.
Arguably, the best-known value-based metric is EVA, which was developed by Joel Stern and G Bennet Stewart in 1982. It was initially sold as a corporate management tool (see box) but is increasingly used by investment analysts to evaluate whether or not a company created long-term value for its shareholders.
The EVA formula subtracts a weighted cost of capital (WACC) from net operating profit after tax (NOPAT). According to the Stern Stewart bottom-up approach, NOPAT is operating profit adjusted for expenses, such as depreciation, the implied interest expense on operating leases and cash operating taxes (see box).
Though the use worldwide of EVA has recently become bogged down in technicalities over how certain inputs should be calculated its use continues to spread.
CFROI can be compared to an after-tax internal rate of return on a company’s existing asset base. CFROI is the rate that sets the current value of the assets after tax cash flows equal to their investment cost. Consultants Holt Associates have concentrated on selling CFROI as an investment tool.
For the man in the street there’s a “quick and dirty” way to see if earnings increases shown in an income statement are real or not: that’s to use the statement of changes in equity to back up the income statement result. Often capital write-downs are reflected here and not in the income statement. If shareholder funds grow at a rate significantly lower than the earnings’ growth rate, investors’ value-creation antennae should twitch.
Profurn provides an instructive example. The group’s equity was allegedly regularly reduced by currency-related write-downs that never appeared on the income statement. That could have – and did – serve as a warning that the group’s expansion programme and accounting practices were aggressive.
The second back-of-matchbox calculation to see if management is returning shareholder value or not is simply to subtract a company’s return on equity from its WACC. If the number is negative then shareholder value is being destroyed.
The downside of this approach is that one-off capital adjustments that hurt earnings – and ROE – will show that value’s being destroyed. That will penalise a company if an event is truly a one-off. But the market rewards managers not just for managing operations but also balance sheets.
As always, there’s no holy grail in investment decision-making – just a number of new tools so that individuals can add to their arsenals.
* Sources: Applied Equity Valuation, edited by Coggin and Fabozzi; CFROI Valuation: A total system approach to valuing the firm, by B J Madden
