As mentioned on my previous post [How Accounting Could be Used to Inflate Revenue] , valuations are commonly based on earnings estimates. Thus, it is not surprising that executives might be tempted to manipulate earnings in order to increase the value of their firm’s stock. In particular, investors tend to respond strongly to any information that may alter the prevailing quarterly earnings trend. If investors could truly derive an accurate forecast of earnings into the distant future, they could properly value stocks. Unfortunately, earnings are subject to much uncertainty, causing any valuation based on expected earnings to be questionable. Many investors have limited time and insufficient skills to develop an accurate forecast of long-term earnings, and therefore they rely excessively on this quarter’s earnings as the key indicator of the firm’s future earnings. Since firms want to please investors, they feed the investors’ short-term earnings addiction. In essence, the investors’ addiction is transmitted to the firm’s managers who are responsible for pleasing investors. Until firms cure their addiction to short-term earnings, investors need to cure their own addiction by understanding the business. How?
Through this post, I reveal how investor can move their focus beyond earnings to cope with deceptive accounting. Effective questions investors should rise to assess the targeted firm. Follow on…
Understand the Business
If investors have the time and the skills, they may be able to derive a better valuation of stocks by looking beyond the earnings. They can more properly judge whether to trust a long-term earnings forecast if they understand the business behind the earnings. An understanding of a specific business can trigger some concerns or suspicions about earnings forecasts, allowing investors to recognize when earnings estimates are misleading. For example: if investors had applied some business concepts to the telecommunications industry during the bullish period in the late 1990s, they would have recognized that it would be virtually impossible for all telecommunications firms to experience the type of growth that some firms and analysts were predicting. Many new firms entered the industry, and a shakeout was inevitable, even if the industry growth had continued. Furthermore, the entrance of new competition was bound to cause more competitive pricing, which would reduce the profit margins of all firms. These basic business concepts were ignored by many investors, who focused completely on attaching valuations to earnings forecasts rather than questioning the earnings forecasts.
There is no valuation model that can derive a precise valuation of a stock when inaccurate earnings are used as input. An understanding of a firm’s business does not guarantee an accurate estimate of the firm’s earnings, but it may at least help investors avoid some stocks whose earnings are suspect. Many investors who do not have the time to truly understand a firm’s business rely on analysts for the valuation. But if analysts focus only on the earnings numbers without really understanding the business, this does not solve the problem.
Therefore, investors should consider the following “checklist of basic business concepts“ before investing in any stock:
Checklist#1: Mission and Strategic Plan
- What is the firm’s mission statement? Normally, the mission is broad, but it can be considered when determining whether the firm is focused on its mission.
- What is the firm’s strategic plan? Some firms establish strategic plans that deviate from their original mission when the prospects in their industry are limited or when competition is fierce. Such a strategy may be rational if the firm has the core competencies and the vision to deviate from its original mission effectively. However, if it is just shifting its business as a means of growth without focus, it is likely to flounder. When firms grow through a series of unrelated acquisitions, investors should question the future direction of the firm. Growth for the sake of growth can lead to costly acquisitions that disrupt the company’s core operations.
Checklist#2: The Business Outlook
- Does the firm have the potential to grow?
- What is the firm’s outlook?
- Is there reason to believe that the firm can achieve its goals?
When using an annual report to obtain information about a firm’s outlook, there is an art to extracting that information. Most businesses (even the efficient ones) are trained to use a positive tone when communicating information. Thus, the term excellence shows up in many mission statements, whether the firm is excellent or is failing. Some firms seem to spend more time on self-promotion than on achieving what they promise in the annual reports. Thus, investors should be cautious about using the annual report to obtain information and should not be influenced by the glowing remarks provided by the firm’s investor relations person or communications person, who was assigned to ensure that the annual report promotes the firm in its most positive light.
Any firm is likely to defend its self-promoting tendencies by arguing that all other firms do it, and that a lack of exaggerated self-promotion would put it at a competitive disadvantage relative to other firms. Of course, this is the same argument that is made by firms who use creative accounting to exaggerate their earnings. To the extent that investors focus on facts rather than hype, the valuation of the firm’s stock should not be influenced by the number of times that the firm uses such terms as excellence, growth strategies, and efficiencies.
If you skim through numerous annual reports, you will notice that a firm’s outlook is typically more positive than its recent performance. Next year is always going to be better than this year. Such optimism is part of the culture, like a New Year’s resolution at the corporate level. Executives may be naïve eternal optimists, or they may believe that investors are gullible enough to believe it. Before you trust the firm’s outlook, at least look back at the previous annual reports to determine whether its outlook in previous years turned out to be accurate.
Firms commonly justify their acquisitions by arguing that they will extract synergies from the combination of businesses or that they will be able to reduce their average costs by eliminating redundant operations of the combined businesses. Yet, many firms do not ever achieve the expected cost efficiencies that they projected as a result of the acquisition. Whether the executives of firms are wrong because they are naïvely optimistic or because they fabricated a reason so that they could build bigger empires through costly acquisitions, their promises of shareholder benefits that will result from an acquisition fall short. In many cases, their compensation increases following an acquisition, even if the acquisition has an adverse effect on the value of the firm. Thus, there is good reason for investors to question this form of growth, even if there is no hidden agenda involving the use of an acquisition as a means of reducing the reported expenses.
Checklist#3: Exposure to the Economy
- How sensitive is the firm’s performance to economic conditions?
- If a recession occurs, by how much will its sales decline?
- Can it survive a recession?
- Does it have substantial fixed costs that will still exist even if sales decline?
Economic conditions are difficult to forecast. Yet, investors should at least be able to recognize how exposed a firm is to economic conditions. At the very least, they can assess how the firm performed during the last period in which economic conditions were weak.
Checklist#4: Exposure to Industry Conditions
- How sensitive is the firm to industry conditions?
- Is there a chance that regulations will increase, which could cause additional expenses?
- Is there a chance that regulations may be reduced, which may increase competition?
- Are there particular industry characteristics (such as asbestos) that are likely to result in lawsuits against the firm?
Checklist#5: Exposure to Global Conditions
- How sensitive is the firm’s performance to global conditions?
- Is it subject to foreign competition?
- Could foreign firms with lower expenses penetrate the market and pull market share away from the firm?
- Is the firm’s performance sensitive to a change in exchange rates?
A firm’s performance is highly influenced by its key decision makers. An understanding of the backgrounds, structure, and incentives of management can help determine whether the decision makers have the skills and incentives to make good decisions.
Background of Managers
- What is the background of the firm’s top managers?
- How long have they been employed by the firm?
- How much experience do they have in the industry?
For a fast-growing firm that is growing in different directions, a danger signal may be the hiring of many executives who do not have much background in the industries that the firm has targeted for growth.
- What is the firm’s organizational structure?
- Does the firm have several layers of managers?
- What is the average cost per employee?
- What is the ratio of total salaries to total assets?
An excessive number of layers of management may reflect inefficiencies. The ratio of total salaries to total assets will vary among industries, but it can be compared within an industry. A high ratio suggests excessive costs relative to assets. An alternative ratio is salaries to sales, which may more directly measure the cost-effectiveness of the firm’s revenue generation.
Does the firm have a high turnover rate? A high turnover of executives in a firm that appears to have been successful recently should trigger suspicion. The turnover may signal negative prospects that are known to the executives but are not yet known to investors. At the very least, it deserves a closer look.
Management Compensation Structure
- What is the firm’s compensation structure?
- Have the top executives earned unusually high compensation even in years in which the firm performed poorly?
If the compensation structure allows high compensation regardless of the firm’s performance, it may not provide the necessary incentives for executives. Even if accounting numbers tell the truth in the future, a firm’s executives may not have an incentive to achieve high performance if their compensation is not properly tied to performance.
Checklist#6: Production Costs
- What is the nature of the firm’s production?
- Does it need a consistently high sales level to cover a high level of fixed costs? Does it benefit from economies of scale?
- Can its production costs be reduced in periods during which sales decline?
Checklist#7: Inventory Control
- Is the firm able to maintain sufficient inventory?
- Does it frequently need to lower prices in order to dump excessive inventory?
Checklist#8: Quality Control
- Does the firm differentiate its product from competitors’ through quality or in some other way
- What is the firm’s reputation for quality?
- Is there any chance that the firm’s sales level will decline because of quality concerns? Is the quality level dependent on one key supplier?
- Is the firm’s performance sensitive to its marketing strategy?
- What is the firm’s channel of distribution from its production to the customer?
- Does the firm rely on intermediaries? If so, what is its relationship with these intermediaries? Is there any chance that it will lose business in the future because the intermediaries push the competitors’ products?
- Does the firm have the potential to increase its product line?
- Does the firm rely on patents and research and development for growth? Does it need to spend substantial funds on marketing just to maintain its market share?
- How does the firm finance its business? Does it rely heavily on debt?
- If so, is there any concern that the firm will not be able to meet its future debt payments?
- What is the cost of the firm’s debt?
- If the firm’s sales decline in the future, can it still afford to cover its debt payments?
- Does the firm have too much stock issued to the public?
- Does it periodically repurchase some of its shares? How does it use its retained earnings?
Are the firm’s managers focused on maximizing the wealth of shareholders? If the firm has a proper governance structure, its managers are more likely to be serving shareholder interests. Consider the following checklist of governance characteristics when assessing a firm.
Background of Board Members
- Are the board members mostly insiders?
- Do the board members have the proper background to oversee the firm’s managers?
- Are the board members also serving on the boards of many other firms?
- What is the compensation structure of the board members? It is difficult for board members to be effective monitors of a firm if they are insiders, or if they have no background in the industry, or if they are serving on the boards of many other firms. In general, board members are more likely to be focused on maximizing the long-term value of the firm if their compensation structure provides them with stock in the firm that they must hold for a long period.
- How much work is involved in being on the board? If all that board members have to do is simply show up at a board meeting every few months, then the board is not playing a significant role in overseeing management. There should be ongoing communication between top management and the board about the direction of the firm’s business and about major policy issues.
- Do board members have access to the firm’s managers? If board members are unable to communicate with managers and are limited to discussions with the CEO, they will not be capable of proper monitoring.
Is there a system in place by which the firm can periodically disclose its performance and financial condition? The financial disclosure in the reports and documents filed with the Securities and Exchange Commission (SEC) should be complete, accurate, and transparent for investors. Employees should be encouraged to inform senior management if any reported information is incomplete or inaccurate.
Checklist#13: Background of the Audit Committee
- Is the job description for the firm’s audit committee members clear?
- Do the members of the audit committee have the ability to ensure that an independent audit will occur? Are they required to have specific credentials to certify that they have the ability that is required for the position?
- Do the members of the audit committee have the ability to interpret and respond to the auditors’ concerns?
- Does the audit committee have easy access to the internal audit department of the firm?
Is the audit committee required to provide a report of the work performed by the auditor to the board of directors?
Checklist#14: Ethics Policy
- Does the firm have an ethics policy?
- Does the firm encourage directors, officers, and employees to report transactions that might be construed as a conflict of interest?
- Does the firm have guidelines regarding gifts from suppliers or other business relationships
- Does the firm have guidelines about contributions that can prevent conflicts of interest?
- Does the firm have guidelines about loans to officers or directors?
- Does the firm have guidelines requiring consultants to be unrelated to officers or board members?
- Does the firm have guidelines that specify the maximum fees that may be paid to business consultants?
- Does the firm have guidelines regarding disciplinary action when one of its senior managers, board members, or other employees engages in unethical activities?
Checklist#15: Insider Trading
- Does the firm have a policy on insider trading or a system for com- plying with rules that prevent insider trading?
- Does the firm define the types of inside information that could be construed as material, so that its directors, officers, and employees can recognize situations in which they should not be trading the firm’s stock?
- Does the firm have guidelines regarding disciplinary action in response to illegal insider trading by its directors, senior managers, or employees?
By asking these common-sense questions about a business, you may be able to detect obvious problems so that you can eliminate a firm with these problems from your list of possible stocks to purchase. Conversely, if a firm is attractive based on the underlying business, the next step is to determine whether the price of the firm’s stock already reflects the value of that business.
There are many good businesses that would not be good investments because their stocks are priced too high. A firm with good corporate governance is not automatically a wise investment. Some firms have a proper structure for reporting their performance, for serving customers, and for serving shareholders, but are overvalued. Their stock price is not warranted by the firm’s business model and the potential cash flows that it can generate. Thus, a check on corporate governance may be a necessary first screen when selecting stocks, but it is not an indicator of undervalued stocks.
Valuation is difficult because it requires you to assign a dollar value based on limited subjective information that is subject to much uncertainty. Yet, you may at least be able to recognize when a stock’s prevailing price is excessive given the information that you have.
Assume the following information:
- Your subjective judgment of a firm’s management is that it is no better than the norm for the industry.
- The firm is just as exposed to industry and economic conditions as most other firms in the industry.
- The firm’s debt ratio and its level of fixed costs are higher than the norm.
- The firm’s price is a relatively high multiple of its expected earnings.
Given this information, you should not invest in this firm’s stock. Without deriving a precise valuation of the stock, you were able to determine that the stock is priced relatively high compared to that of some other firms in the same industry, and that the stock’s price is not justified by the firm’s general business characteristics. In other words, if you really wanted to capitalize on favorable expectations about the prospects for that industry, you would probably invest in some other firm in the industry.
Some investors prefer a more precise method of valuation, so that they can directly compare their valuation to the prevailing market price of a stock. However, such a valuation must either convert subjective information into a formula or ignore the information. One compromise is to apply a quantitative model based on expected earnings or other objective (but possibly manipulated) data and to complement the analysis with a subjective assessment of the firm. In this case, the decision to invest in a stock would require both a valuation that is lower than the prevailing price and a favorable subjective assessment of the firm. When a firm has unfavorable characteristics, investors tend to use various methods for discounting the valuation, all of which are subject to error. For example: they may discount a firm’s valuation by 5 percent because of the likelihood that new competitors will enter the industry in the next few months. These efforts to quantify subjective information allow investors to derive a specific valuation of the firm’s stock, but they essentially create a decision model that is even more arbitrary than just using common sense to develop a subjective assessment of the firm.