2.3 Figures and Transparency
The reported, audited financial figures form the basis of every company valuation.
Investors and financial analysts spend a lot of time analyzing and extrapolating from the balance sheet, the income statement, the statement of changes in equity, and the statement of cash flows and the trends underlying them.
This is easier said than done, as various factors make it difficult for investors to read the financial figures and, above all, the income statement. Three can be mentioned here as representative of the many others:
- Firstly, the income statement maps both recurring and non-recurring items, such as revenue on the one hand and the sale of assets on the other
- Secondly, both effective costs, such as personnel expenses or rent, and also expenses of an investment nature, for example for research or the development of new software, are reported as costs
- Thirdly, various items in the income statement such as expenses for share options or amortization and write-downs of intangible fixed assets, are based on estimates
Adjusted Figures
In the wake of the opaqueness in these and other areas, many companies have switched to publishing adjusted figures in addition to the audited results. These are frequently also called alternative performance measures, pro forma figures, or non-GAAP measures. There is nothing wrong with this in principle, if the individual items and effects are reported consistently over time as either ordinary or extraordinary. And if it is not only costs that are presented as non-recurring items but non-recurring profits, too.
The problem with adjusted figures is that they are susceptible to improper embellishment. This is true in particular if the variable compensation of the management is based on pro forma figures and not on the profit reported in accordance with accounting regulations. One of the issues closely monitored by exchange supervisory authorities is that companies immediately identify alternative figures as such in their communication tools and show how any adjusted figures are derived.
EBE – Something to Smile About
As an extreme example of an adjusted figure, cynics put forward the EBE, «earnings before expenses», in the style of Luca Pacioli, who, around the year 1500, was the first person to produce a complete description of double-entry bookkeeping
The regulations governing accounting require much more detailed reporting today than 20 or 30 years ago. In comparison with 20 or 30 years ago, investors rely less on these financial figures today in their valuations. Studies show that the reported profits and carrying amounts explain around only half of the company valuation – once it was around 80 percent. The reason for this is the increasing importance of intangible assets, whether it be patents, research efforts, trademarks, or business processes, that are not mapped either in the profits or in the carrying amounts.
Communicate More Than Just the Mandatory Information
In the course of this development, companies have switched to publishing other information in addition to the obligatory material. This can include for example:
- Incoming orders of an industrial company
- Figures on the POS of a retail company
- Development of the research pipeline of pharmaceutical and biotech companies
- Valuations of the individual properties of real estate companies
- Number of customers and acquisition costs per customer of an Internet company Sustainability report
This will sometimes involve precisely this presentation of intangible assets but always the dismantling of information asymmetries. Whether a company wants to publish information of this kind will require careful consideration. Studies have shown that when companies provide more precise information on the current situation and the way forward, the cost of capital and price volatility is lower. Even a direct correlation with trading volume and the bid-ask spread has been documented. Among the reasons put forward against this kind of transparency that goes beyond the mandatory program are generally possible disadvantages in relation to the competition and the greater probability of legal action.
Because they are convinced of the stated advantages, a lot of companies communicate this kind of information in excess of the annual financial statements. In order that this information is also useful for investors, it must be collected and published in a systematic and standardized way. Furthermore, there must be a direct cause-and-effect relationship with the financial figures. These criteria are fulfilled for example by incoming orders in industry or the development of a biotech research pipeline mentioned earlier. Less valuable from this point of view are, for example, the results of customer or employee surveys.