Members of The Robert Morris Associates (RMA) are users of financial information, not issuers. As a user group, RMA's primary interest is that financial reporting be timely, complete, relevant, reliable and understandable. Accordingly, it focuses on the results obtained from financial accounting concepts and standards and from generally accepted auditing standards, rather than on the detailed procedures followed to obtain those results. Technical aspects of accounting are the responsibility of the accounting profession, being of less importance to users than is the information content of financial reports. [RMA90, p. 1]
RMA's views on accounting and financial reporting issues are from the financial statement users' perspective and, more particularly, from the perspective of those who lend or participate in the lending process. Lenders are primarily interested in assessing the ability of borrowers to repay debt. The first and preferred route is to be repaid from the cash flows of a going concern. The fallback source of cash is from the liquidation of the borrower's assets, either individually or in toto. In turn, lenders look for accounting information that allows them to assess the probable amounts and timing of their customers' future cash flows, as well as informing them of the assets available for liquidation and the nature of the queue of creditors with claims against those assets. [RMA90, p. 1]
__________
The buy-side analysts surveyed followed an average of ninety-three corporations each and worked in firms averaging $7.2 billion in assets under management, distributed as follows:
* 21.5 percent—firms with less than $1.0 billion under management
* 60.7 percent—firms with $1.0 to $9.9 billion under management
* 17.8 percent—firms with $10.0 billion or more under management [SRI, p. 13]
Sell-side analysts are the securities analysts at broker/dealer institutions that serve both individual and institutional buyers and sellers of corporate securities. The sell-side analysts surveyed followed an average of forty-one corporations. [SRI, p. 13]
Brokers (registered representatives) are the professionals who deal directly with individual and institutional investors. The brokers surveyed were responsible for an average of 157 accounts or clients. Retail brokers averaged 208 clients, and institutional sales brokers averaged 105 accounts. [SRI, p. 14]
In general, the professionals are a skeptical group with a quantitative orientation to their work, an appetite for detail, and a distaste for what they perceive as exaggeration and incomplete disclosure. Their skepticism focuses mostly on the qualitative aspects of corporate information, especially on corporate disclosures and explanations of problems and poor performance. They have greater confidence in "the numbers," although even that feeling is tempered by the knowledge that, despite financial reporting standards established by such bodies as the SEC, the Financial Accounting Standards Board, and various industry regulators, corporate management still has great latitude in its selection of accounting rules, interpretations, cost and revenue allocations, and the like. [SRI, p. 14]
Specifically, the professionals believe that corporate managers naturally tend to disclose their company's performance in the most favorable light. Although they have confidence in management integrity, they state that managers commonly procrastinate in disclosing problems and that many managers express a more optimistic view of their company's situation that seems warranted by the professional's own analysis. Professionals have high praise for those companies whose executives do completely and candidly disclose their performance; in fact, many regard such disclosure as an indicator of the competence and self-confidence of the management group. [SRI, p. 14]
The professionals want as much first-hand information as possible, preferably from senior executives, especially the CEO. As one professional said, "I want to be able to see the CEO's eyes when he tells me about his company." Professionals are confident that they can detect exaggeration, incomplete disclosure, and misrepresentation (in the few instances when that occurs). They are equally confident in the ability of market forces to reveal the facts, although perhaps not quite so quickly. [SRI, p. 14]
Without exception, all analysts, portfolio managers, and brokers regularly review numerous sources of information—some to determine long-term performance of companies and their securities and some for up-to-the-minute monitoring of events affecting their investments. On average, the professionals surveyed examine twenty-five to fifty different types of information sources. When questioned on the need for such a variety of sources, they cited the following main reasons:
* No one, two, or three sources provide all the information needed to make a valid investment decision. [SRI, p. 15]
* Because every information source has its biases, a variety of sources must be reviewed to develop an objective view. [SRI, p. 15]
* A few sources provide basic and very important information; the other sources are used to confirm and enhance the information in these primary sources. [SRI, p. 15]
* Because so much of the available information is inexpensive, using a large number of sources is easy. [SRI, p. 15]
The sell-side analysts demand the most complete, objective information; the buy-side analysts and portfolio managers are only slightly less demanding, followed by the institutional sales brokers and the retail brokers. Brokers, however, rely heavily on the work of the sell-side analysts; their recommendations are thus based on high-quality information and analyses, even though they usually do not analyze the data themselves. [SRI, p. 15]
Except for some common techniques used to evaluate financial statements, the professionals analyze the plethora of available information in diverse ways. Some rely completely on quantitative data, others on qualitative information (company plans, reputation, market position, and the like), but most require both kinds of information to make decisions. A number of the more sophisticated analysts, and those with the necessary technical skills, have invented their own analytical framework and algorithms; most employ some individualized theory in their analysis. Without exception, however, every professional admits that subjective or intuitive judgment significantly affects his or her investment decisions. [SRI, p. 15 and 17]
The larger investment firms tend to have elaborate procedures, involving several layers of managers and committees, for making and reviewing investment decisions. The smaller firms tend toward simpler, sometimes one-stop decision making. In some instances, the portfolio manager is also the principal analyst for a portion of the portfolio. Some firms establish specific criteria that must be met before a security can be bought or sold; others use ad hoc methods and rely on the decision maker's judgment applied in an unstructured way. [SRI, p. 17]
The most important part of the investment process, the purchase or sale of securities, is the simplest. For buy-side professionals, the approved purchases and sales are executed immediately or as part of a planned portfolio shift. For sell-side professionals, the process involves placing approved securities on a "recommended for purchase" list and then recommending these stocks to appropriate clients. [SRI, p. 17]
[U]nsophisticated [individual] investors actually consist of two distinct segments, which have been descriptively named "buy-and-hold" investors and "opportunity-driven" investors. The sophisticated individual investors have been designated as "semiprofessional" investors to differentiate them from the sophisticated professional investors whom the semiprofessionals resemble in some ways. [SRI, p. 19]
[Buy-and-hold individual investors] with only simple information needs, . . . draw on fewer sources of information than the other segments. Their decision-making process is primarily intuitive; their investment motivation tends to be security oriented, with a buy-and-hold philosophy dominating. [SRI, p. 19 and 22]
Opportunity-driven [individual] investors continually scan a wide variety of information sources so as to spot opportunities to improve their portfolios. Their investment decision making is not much more sophisticated than the buy-and-hold segment's, with an equally high dependence on intuition and information processed by experts such as analysts of brokers. Their basic investment philosophy is to increase their holdings and generate earnings. They are independent decision makers, relying on advisors for the information they provide more than for the advice they offer. [SRI, p. 22]
[S]emiprofessional investors are highly proactive in their investment activities. They have a trading mentality (averaging twenty-nine trades per year), meaning that they actively and continually monitor the market, seeking opportunities for short- and long-term gains as well as advantages created by price fluctuations. Their decisions are grounded in a good understanding of investment fundamentals, exposure to a broad array of information, and an appreciation for analysis (whether they buy it or do it themselves). [SRI, p. 22]
[A]bout half of the individual investors surveyed feel well-qualified to make their own investment decisions, but most do not consider themselves to be sophisticated investors. Furthermore, all but a small number of investors actually do make their own investment decisions, with only about 15 percent of investors delegating that responsibility to others. The majority of investors are assisted by advisors, published investment information, or both. Only the more sophisticated investors feel qualified to make completely independent investment decisions. [SRI, p. 22]
The investment decision-making process of individual investors is far less precise than earlier studies have indicated. Even among the more sophisticated investors, subjective judgment, intuition, and "gut feel" are at least as important to the process as logical thinking and analysis. [SRI, p. 24]
[T]he great majority of individual investors base their investment decisions on little more than "impressions" and "intuition" resulting from the continual scanning of numerous sources of information and from contact with various people whose advice they sought. Only a small number followed a structured, analytical decision-making approach. Decision-making behavior correlates closely with the individual investor segments identified earlier; indeed, this was one of the elements used in defining the segments. [SRI, p. 25]
Individual investors use four general approaches to decision making: delegation, advisor dependency, informed intuition, and analysis. [SRI, p. 25]
Variety is the word that best characterizes the information sources used by investors. Individual investors, in aggregate, say they use thirty-nine different types of information sources, while professionals say they use fifty-seven different types. Why so many? No single source contains all the information investors feel they need to be well informed. They also want to compare information presented in several sources to help eliminate biases and to obtain various interpretations of the same data. [The following two] tables show the sources most used by individual investors and professionals:
Sources of Investment Information for Individual Investors Percent Rank Source Using 1 Company annual reports 59.3% 2 General newspapers 49.3 3 Wall Street Journal 41.5 4 My broker 28.2 5 General business publications 27.4 6 Personal contacts 26.1 7 Company quarterly reports 20.8 8 SEC filings and prospectus 14.9 9 Investment information services 14.7 10 Brokerage firm analysis/reports 13.0 11 Trade association/publications 7.1 12 My investment advisor 6.6 13 Television 5.7 14 Company press releases 5.4 15 Investment letters 4.5 16 SEC Form 10K 3.6 17 Proxy statement 2.8 18 SEC Form 10Q 2.8 19 Shareholder meetings 2.0 20 Radio 1.2 Note: Other sources with less than 1.0 percent usage were product brochures, company employees, company officers, investor relations programs, company advertising, computer data services, accountants, personal research efforts, attorneys, bank officers, financial planners, and libraries. Source: SRI International survey, 1986. [Also included in 1(b)] [SRI, p. 33] Sources of Investment Information for Professional Investors Percent Rank Source Using 1 Company annual reports 84.6% 2 SEC Form 10K 62.2 3 Company quarterly reports 57.4 4 Other analysts or professionals 54.8 5 Company management 53.8 6 Investment information services 47.1 7 SEC Form 10Q 44.2 8 Company press releases 42.6 9 General business publications 37.2 10 General newspapers 34.0 11 Wall Street Journal 32.1 12 Trade associations/publications 26.6 13 Company fact books 17.6 14 Personal contacts 17.6 15 Analyst meetings/presentations 16.0 16 SEC filings/prospectus 12.8 17 Other analysts in my own firm 12.5 18 Investment letters 11.2 19 Company competitors 10.3 20 Proxy statements 9.6 21 Wire services 6.4 22 Company customers 5.1 23 Government reports/publications 4.8 24 Company suppliers 3.2 Note: All other sources had no more than 1.6 percent usage and included speeches and interviews of company officers, product literature, rumors, employee publications, Quotron, industry seminars, shareholders, credit reports, and former employees. Source: SRI International survey, 1986. [Also included in 1(b)] [SRI, p. 34] __________Some [sell-side analysts] use . . . contrarian logic, which has been empirically refuted. For example Solt and Statman [1988] showed the futility of the Bearish Sentiment Indicator. Yet contrarian analysts survive. [PREVITS, p. 11]
[Sell-side] analysts use a combination of fundamental techniques in developing a recommendation on a company. Fundamental analysis is used to forecast performance and assess condition. Technical analysis is used most frequently to predict the movement of a company's stock price, given the results of the fundamental analysis. [PREVITS, p. 11]
Most sell-side analysts recommendations fit into three general categories: buy, sell, and hold. Buy recommendations predominate. Sell recommendations are extremely rare. According to Zacks Investment Research, recent recommendations were 50% buy, 42.5% hold, and 7.5% sell. . . . [PREVITS, p. 11]
There are several plausible explanations for this [sell recommendation] distribution. First, brokerage firms earn commissions through selling securities, and need to identify undervalued securities to promote. Similarly, brokers that manage a public offering of a company's have incentives to issue buy recommendations. The rarity of sell recommendations may be attributed to the heavy reliance that sell-side analysts place on management sources for company information. Analysts seem to be concerned that management will become less available and forthcoming if "sell" recommendations are made. [PREVITS, p. 11]
Recent press reports allege that difficulties [relating to a heavy "buy" climate] exist at major brokerage and investment houses [e.g. Morgan Stanley; Kidder, Pea body] and concern major stock [e.g. Dell Computer; Microsoft]. [PREVITS, p. 11]
[S]ell-side analysts may be more subtle in their signaling. There are a variety of types of buy and hold recommendations, and analysts may qualify their recommendation in the text of the report. This provides the basis for a relative ranking of companies such that, given that investor resources are not unlimited, weak hold recommendations can be viewed as sell signals. A few analysts reports are more general evaluations that do not contain specific recommendations. [Also included in 1(c)] [PREVITS, p. 11-12]
In assessing individual company's performance over time, analysts speak of "easy" and "hard" earnings comparisons with earlier equivalents periods. Analysts show awareness of earnings management, for example in commenting on the easy earnings comparison of a company occasioned by a "big bath" taken in the year earlier period. They are particularly interested in identifying company trends and changes affecting company trends. Directional phrases such as "change(s)", "increase", "decrease", "decline", "new", and so forth, occur thousands of times in the full sample [of the study]. [Also included in 1(c)] [PREVITS, p. 12]
[Sell-side] analysts often organize their reports so as to provide information that supports their EPS forecasts but also provide a list of "risks" or "concerns" that could negatively affect a company's performance. Corporate auditors are identified or commented upon infrequently [in analysts reports], however in one instance a change in auditors was listed as a "risk factor" [Also included in 1(c), 10(d), and partly included in 17(f)] [PREVITS, p. 12]
A standard, if somewhat simplified, approach taken by most analysts in forming recommendations is as follows. Disaggregate the company's operations into as fine a set of operating units as possible and develop earnings forecasts for each unit. This reduction is much finer than GAAP. For example one report commented that a company "reports two lines, but there are actually three". Analysts regularly discuss the above matters with respect to each operating unit. For example, one waste removal company was analyzed by individual landfills; a gaming company was analyzed by individual casinos, etc. [Also included in 1(b), 1(c), and 3(e)] [PREVITS, p. 12]
[A]nalysts employ "common size" financial report formats repeatedly. The technique used is to present each key element of the balance sheet and income statement for comparative periods in percent terms of a key number of the statement so sized such as total assets or net revenues. [PREVITS, p. 13]
[Equity sell-side] analysts distinguish between valuations based upon the company's continued existence in its present form: so called fundamental value, and valuations based upon acquisition or breakup of the company. Analysts use several approaches to valuing companies based on fundamentals, most typically in terms of the present value of the company's cash flows, its earnings, or balance sheet valuations. In this approach analysts also distinguish between a company's "Public market value" and "private market value". For example, one analysts measures the fundamental value of a company in terms of:
1) Private market value
2) Price/revenues
3) Price/book value
4) Price/long-term earnings
5) Growth-driven valuation composite
6) Contrarian composite [e.g. Bearish Sentiment Indicators]
7) Earnings momentum composite
8) Technical ranking
9) Beta
[Also included in 1(b), 1(c), and 4] [PREVITS, p. 19]
[One] analyst valued companies in terms of revenue, cash flow multiples, and net income. And yet another analyst valued a cable TV company with purported off-balance-sheet assets on three basis:
1) present value of cash flows,
2) appraised value of assets and
3) the company's liquidation value.
[Also included in 1(b), 1(c), and 4] [PREVITS, p. 19]
Another analyst evaluated the same cable TV company by analyzing each of the many limited partnerships with which the company was related in order to estimate the long-range cash flows of each to the company. [Also included in 1(b), 1(c), and 4] [PREVITS, p. 19]
Analysts label valuations of a company based upon it acquisition or breakup as it "buyout value", "breakup value", "takeover value", "theoretical breakup value", and so forth. Examples of computed break up value include the following:
1) Estimated breakup value = asset values at market price less liabilities.
2) Adjusted breakup value takes the above and adds other "likely" assets.
3) Possible breakup value adds other "possible" assets to all of the above.
[Also included in 1(b), 1(c), and 4] [PREVITS, p. 19]
[The] content analysis of [the] word usage by sell-side equity analysts and bond rating analysts suggest that traditional statement content plays an important but incomplete role in developing analysts reports. Each group emphasizes different statements. Equity analysts are income/performance driven and debt analysts are balance sheet/leverage driven. [PREVITS, p. 21]
The needs of analysts go beyond the historical cost, transaction matching model of traditional statement based reports. Equity analysts provide softer, more frequent and more comprehensive details using subjective interpretations from a collection of micro and macro information so as to construct scenarios of likely alternative prospects of the company. [Also included in 13] [PREVITS, p. 21]
As such traditional statements fulfill their expected role of providing historical perspective useful to analysts interested in developing outlooks based on an objectively reviewed performance report, conservatively stated. [Also included in 13] [PREVITS, p. 21]
To the extent that earnings, earnings momentum and earnings potential drive the equity analytics of sell-side reports, the need for more frequent than annual information on performance is clear, as is the need for more finely disaggregated performance information, in common sized formats to enhance intercompany comparisons. [Also included in 2(c), 3(c), 3(d), and 11(a)] [PREVITS, p. 21]
The merit of additional cash flow ratio analysis reporting . . . seems worth examination. [PREVITS, p. 21]
__________
The Association for Investment Management and Research (AIMR) was formed through a merger of the Institute of Chartered Financial Analysts (ICFA), founded in 1962, and the Financial Analysts Federation (FAF), founded in 1947. . . .[AIMR/FAPC92, p. 1]
AIMR members are investment management professionals. Membership includes securities analysts, portfolio managers, strategists, consultants, and other investment specialists. Members practice in fields such as investment counseling and management, banking, insurance, investment banking and brokerage. Of AIMR's 22,581 members, 14,513 (64%) hold the designation Chartered Financial Analyst (CFA) in recognition of their accomplishment in passing all of the three CFA examination parts. Seventy-one percent of AIMR members hold degrees beyond the baccalaureate. Eighty-six percent are located in the United States, ten percent in Canada and the remainder in other countries. [AIMR/FAPC92, p. 1]
Investment management professionals often are categorized by activity into what are called "buy- side" analysts and "sell-side" analysts. The latter are likely to be employed in the research departments of investment banking and brokerage firms. Their reports tend to focus on individual companies and in larger firms they specialize by industry. The work of buy-side analysts is less often seen because it is usually produced for confidential use by the analyst's employer, more often than not a portfolio manager or investment counselor. [Note added by staff--According to Committee members at a meeting with FASB, March 12, 1993, membership of AIMR is about 50 percent buy-side analysts, and their proportion is growing.] [AIMR/FAPC92, p. 1]
In addition to analysts employed in the securities industry broadly defined, AIMR members engage in an impressive range of other employments. There are many analysts employed by business and consulting firms who are engaged in competitive analysis, the appraisal of competitors within their industry, and analysis of potential acquisitions. There are analyst specialists, such as those who concentrate on accounting issues or other technical support areas within a financial firm's research department. A small number of AIMR members are academics. [AIMR/FAPC92, p. 1]
A recent survey by AIMR's Financial Accounting Policy Committee (FAPC) showed that virtually all of these investment professionals used financial reports in their work either directly or indirectly. Several of them utilize financial information accumulated in and accessed through databases. At the other extreme, many of them read volumes of financial statements in complete detail. Others fall in between and may combine the use of databases with reading financial reports in detail on a selective basis. [AIMR/FAPC92, p. 1]
. . . Many of AIMR's advocacy efforts are expended in the realm of financial reporting and corporate information. The AIMR Corporate Information Committee (CIC) each year publishes a report that evaluates the quality of corporate financial reporting in selected industries and makes awards for excellence. [AIMR/FAPC92, p. 2]
The Financial Accounting Policy Committee (FAPC) maintains contact with both private and public sector accounting groups that establish accounting standards to assure that the needs of investors are communicated and included as standards are promulgated. . . .[AIMR/FAPC92, p. 2]
This report continues the tradition of occasional position papers by the Financial Accounting Policy Committee. As such, it presents the views of the largest and most important organized group of financial statement users in our economy and in the world. [AIMR/FAPC92, p. 2]
__________
In recent months both the American Institute of Certified Public Accountants (AICPA) and the Financial Executives Institute (FEI), the groups representing, respectively, the main bodies of auditors and preparers of financial statements, have begun work on major projects to study financial reporting. In 1991, the Financial Accounting Foundation, the parent and sponsor of the FASB, formed an oversight committee of its board of directors to evaluate the operations and product of the FASB. Thus, in the financial reporting milieu, the standard-setting body, preparers of financial statements, and auditors all are in the process of presenting their views to the world. AIMR, as the primary organization representing financial statement users, needs to be heard at least as clearly and resoundingly as other groups involved with financial reporting. [AIMR/FAPC92, p. 3]
In the past FAPC position papers have been addressed to groups responsible in some way for accounting standards setting. This report seeks a broader audience. Its primary purpose is to influence the opinions and actions of: (a) managements of the companies that prepare and issue financial reports; (b) accounting standard setters and securities markets regulators, who set the parameters within which those reports must fall; and (c) independent auditors, who attest to the fairness of those reports. The over-riding message to each of those groups is that the purpose of external financial reporting is to serve the needs of those who use it. [AIMR/FAPC92, p. 3]
This report also is one of the initial major policy initiatives since the formation of AIMR. Previous works of its predecessor bodies, the Financial Analysts Federation and the Institute of Chartered Financial Analysts, represented the views of their separate constituencies. Now, we have the opportunity to produce the first of what we hope will be a series of policy statements and reports that will present the collective views all securities analysts and other investment professionals. [AIMR/FAPC92, p. 3]
[Context] The AIMR position paper, Financial Reporting in the 1990's and Beyond, comprises 72 pages on a variety of subjects that are pertinent to the work of the Special Committee on Financial Reporting. Most of the 19 categories in the Special Committee's database include excerpts from it, usually introduced by a paragraph or two from its "Executive Summary" (pages vi-x).
The position paper provides the following summary of the section (pages 6-11) entitled "Financial Analysis and Financial Reporting":
This section provides primarily descriptive information. It discusses the interrelationship between the efficient market hypothesis (EMH) and other theories of financial economics and the role of financial analysis in making markets efficient. It presents a description of the analytic process to the extent that generalizations can be made in that area. It lists and describes the vast variety of information sources used by analysts, of which financial reports are an indispensable part of the whole. It then describes in more detail each of the financial reports analysts rely on in their work. [Also included in 1(b) and 1(c)] [AIMR/FAPC92, p. vi]
One of the most important points made in this section is defining the distinction between financial analysis and financial reporting. We believe that financial reporting should be concerned with presenting the economic history of specific economic entities and that it is best done when managements also are willing to disclose and discuss their strategies, proposed tactics and plans, and their expected outcomes. Forecasts of the future and similar material enhances financial report usefulness, but must be separated from and not confused with the financial statements themselves. The function of analysis is to allow those who participate in the financial markets to form their own rational expectations about future economic events, in particular the amounts, timing and uncertainty of an enterprise's future cash flows. Through this process, analysts form opinions about the absolute and relative value of individual companies, make investment decisions or cause them to be made, and thereby contribute to the economically efficient allocation of capital and clearing of the capital markets. [Also included in 1(b) and 1(c)] [AIMR/FAPC92, p. vi]
[Context] Those two paragraphs introduce the following excerpts and relate them to excerpts from the same section included in 1(b)-Types of information that investors and creditors use. . . and 1(c)- Investors' and creditors' use of information to achieve their objectives.
The Nature and Role of Efficient Markets
Over the past twenty-five years or so, a great literature has been created that supports the hypothesis that financial markets are, to one degree or another, efficient. How efficient is a matter of debate among both practitioners and academics even today. In its most basic form, the efficient market hypothesis (EMH) states that information is quickly impounded in stock prices. The implications are that one cannot profit by having access to information that also is available to others. The evidence supporting the EMH is voluminous in the literatures of economics, finance and accounting. There also is abundant literature that points out anomalies in the EMH. The degree to which market efficiency actually exists is a matter that will continue to be debated for some time to come. [AIMR/FAPC92, p. 4]
What we all may agree upon is that information does affect stock prices eventually. The corollary is that markets could not possibly be efficient if information were not available. In addition, those who either lack information or who do not understand the information that is available to all are at a distinct disadvantage in buying or selling securities. Therefore, no matter how efficient or inefficient a financial market may be in fact, information is its lifeblood. [AIMR/FAPC92, p. 4]
Financial information comes from many sources and in many forms. Much of it is received by financial analysts prior to the issuance of financial reports. The news wires are filled with items giving information about major events affecting various companies: new contracts, new financing, legal actions, product introductions, patent grants, capital spending plans, personnel changes, and the like. Companies send out press releases, hold analyst meetings, and otherwise see that news affecting them is presented in its most favorable light. Much of the information that moves the market is qualitative in nature and requires subsequent verification. It is used by analysts to form estimates of future earnings and cash flows and to draw conclusions as to whether a particular company's securities should be bought, held or sold. [AIMR/FAPC92, p. 4]
Financial statements and other formal financial reports are usually produced some time after the fact. They provide analysts the assurance that their initial interpretations of company news were sensible and to some degree accurate. Sometimes it is asserted that financial statements do not contain news, i.e. new information. Analysts hope that assertion is true. If it is, that means that both the companies and the analysts that follow them have done their jobs successfully in making the market as efficient as can be. When a financial statement contains one or more "surprises" that cause a market price to change, one usually may conclude either that the analysts lacked perspicacity or that the company engaged in duplicity. [AIMR/FAPC92, p. 4]
Although a financial report may not contain "news," that does not mean that it does not contain information. Later in this report, we point out the many ways in which such reports provide not only a record of the past, but also clues to the future and a myriad of detailed data not available elsewhere. The overriding mission of this report is to discuss in detail exactly how that information should be presented so as to be of the optimal use to financial analysts and, in turn, to the efficiency of capital markets. [AIMR/FAPC92, p. 4]
Analysts Look for Anomalies Between Price and Value
The function of markets is to set prices and effect transactions. The function of financial analysis is to assess values. If markets were truly efficient, price would adjust quickly to value as information became available and its implications were understood. However, even in the most efficient of markets, different people assess value differently. The dividend discount model (DDM) valuation framework is often used to estimate the worth of a security as the present value of its future dividends plus its residual price discounted at a risk-adjusted rate of return. The capital asset pricing model (CAPM) provides an analytical framework to relate expected return and risk. However, tolerance of risk varies among individuals, as do estimates of the amounts, timing and uncertainty of future dividends. A market price is at the margin: persons who continue to hold securities believe them to be worth at least their market price; and to be appropriate to the portfolio. [AIMR/FAPC92, p. 5]
Financial analysts look for market price anomalies, securities whose values are perceived to be different from their current market prices, usually greater but sometimes less. In doing so, analysts form projections of future earnings, usually as a surrogate for estimating future cash flows. Major events in the economic life of a company may cause analysts to reassess the company's future earnings and may in turn be reflected through significant changes in the market price of the company's securities. Analysts' reports are used by securities firms to make buy, sell or hold recommendations. Portfolio managers and other investors actually make buy-sell-hold decisions. As investors change their minds about the values of individual securities, they change their portfolios accordingly. Thus, capital is allocated efficiently and impersonally to its best use in the economy. [AIMR/FAPC92, p. 5]
Financial analysts also participate in due diligence proceedings, advising deal makers and investors as to the economic values underlying proposed transactions. Other analysts prepare valuation studies to assess competition and competitors. Others are consultants on valuation. In sum, if markets are efficient, they are made so by the work of financial analysts who continually are seeking to find discrepancies between price and value, and who advise on portfolio transactions accordingly. This moves market prices toward price-value equilibrium. [AIMR/FAPC92, p. 5]
Growth in the Size of Institutional Ownership of Securities
Ever since World War II the proportion of securities, particularly common stock, owned by institutions has grown continuously. At the end of September, 1991, only 54.5% of total equities were held by households, down from 91.3% in 1950. The rest are held by mutual funds, pension plans, philanthropic and educational organizations, etc. The rise of institutional ownership is subject matter for a different report than this, but it does have two distinct implications for financial analysis. [AIMR/FAPC92, p. 19]
As the proportions of shares owned by institutions increases, so does their proportional ownership of individual companies. In fact, some ownership interests are so large that the institution cannot make meaningful changes in its portfolio without consequential effects on the market price of the shares being traded. The sheer size of some fund groups, such as the California Public Employees Retirement System (CALPERS), makes it difficult to have investment aspirations beyond matching the movement of the markets as a whole. To such large institutions careful evaluation and analysis of the financial reports of individual companies may not always be a useful activity because it is economically infeasible to act upon it. [AIMR/FAPC92, p. 19]
However, it is only the truly mammoth funds that are precluded from achieving consistent above- average returns. As a counter example we offer the case of the Fidelity Magellan Fund which, under the management of Peter Lynch, realized consistent above-average returns year after year, despite being one of the largest mutual funds in the world. Other successful funds, such as Vanguard's Windsor Fund, have stopped or suspended accepting new investors in order to preserve the flexibility they need to act in the market. In those cases, the principal reason for the fund's success is the careful screening and evaluation of individual companies. [AIMR/FAPC92, p. 19]
A second notable implication of the rise of institutional investors is the increased need for financial reports written for and directed to the professionals who actually select or otherwise recommend the securities owned by institutions. Individual investors no longer should be considered the primary target audience for financial reports. It would be scandalous to deprive professional investment advisors, portfolio managers, and other financial analysts of information they need on the flimsy grounds that those data might confuse individuals who do not understand accounting. After all, those who profess to use financial reports bear some responsibility to educate themselves on how to read them. [AIMR/FAPC92, p. 19-20]
__________
[Context] Meeting of the Investor Discussion Group on October 16, 1992. Participants were presented with a description of five basic categories of objectives and approaches that investors use: the cross-sectional approach, the fundamental analysis approach, the anticipation approach, the technical approaches, and the combination approaches. With respect to those categories, they were asked three questions:
* What is their objective and approach to evaluating equity securities?
* Is the list of objectives and approaches accurate?
* What is the relative popularity of the various objectives and approaches among sophisticated investors?
Participant I-8
My approach is the fundamental analysis approach. My approach is to try to find companies where there was a period of significant growth and the company was viewed as a growth company. The company sold at a high valuation, something went wrong; the value or the price of the stock is down very substantially. The things I'm looking for are whether the stock is cheap on every basis. The objective that I'm looking for is a very substantial capital appreciation if I'm right and the company resume some growth pattern. [TI 10/16, p. 2-3]
Participant I-6
As a fundamental analyst, I try to forecast earnings. In order to forecast earnings, you have to have a basic understanding of what the company is doing and how it does it. That includes an understanding of the product and the market for the product and, basically, when you look at financial reports, the only thing they tell you is a bunch of numbers that are financial related, but it would help if we knew what the quantity was of what the company produces. There is also a lack of compliance with FAS 14 on segment disclosures. So when we try to forecast earnings and we don't know the quantity of products the company produces, it's very hard to really forecast those earnings. [Also included in 3(a) and 13] [TI 10/16, p. 3]
Participant I-7
Within our organization, there are probably 100 analysts. For the most part, we are very industry specific. [Participant I-6] will follow metal companies, I will follow electrical equipment companies, such as [names deleted] and the likes. One of my primary functions is to directly influence the buy, hold, sell investment decision-making policies on companies in my industry. Within that context, if I had to focus on one single element that is extremely crucial, it's earnings. I also agree with [participant I-6], there is a FAS 14 on the books which for the most part is useless. Either the companies are dismissing it or using it to show how they would like to be viewed from an external point of view, but I would like to see a company the way it looks at itself from an internal point of view. Most of the FASB presentations absolutely don't do that. [Also included in 3(a)] [TI 10/16, p. 3]
Participant I-12
I am a fundamental analyst and I cover a wide range of industries. Basically, an analyst's job is to forecast future cash flows and future cash flows often bear no resemblance to reported earnings. The reason for that is that a dollar in your hand is not necessarily a dollar that the accountants recognize. What we analysts have to do is to take the basic financial statements and attempt to find out how much of that is cash and how much is not cash, but rather an accounting convention. Over the years, as the accounting profession tried to keep up with the innovations, they made some determinations about how those transactions should be recorded and, in some cases, those determinations further hide the real cash flows of the company. I think, for example, in terms of present value accounting issues where companies are given enormous latitude in some respects. [TI 10/16, p. 3-4]
Segment reporting is something that is absolutely critical to an analyst. For example, for [a large, diverse financial institution], the cash flows generated by the credit card business have entirely different sources and uses than the cash flows generated by the securities business. It's very difficult from what we see to find that out and find a base from which we can forecast. [Also included in 3(a) and 3(b)] [TI 10/16, p. 4]
Participant I-1
A pure quantitative approach has been left out. A quantitative approach would not necessarily be concerned with what the company does; they're relying more than the fundamentalists on the data that is generated by historical financial statements. [TI 10/16, p. 4]
Under the fundamental approach, you are overlaying more judgment to the numbers. So you are concerned with the markets, the customers, the critical variables, all the things you don't generally get from financial reporting. I find historical financial statements to be virtually worthless as a fundamental analyst. I could virtually not have the front part of the financials if you put notes disclosing significant litigation, asbestos liability, unfunded pensions plans: that is probably the most I get out of the historical statements. You have to start some place, but I'm not sure that gets you too far. [Also included in 1(b)] [TI 10/16, p. 4-5]
Participant I-4
I think historical numbers are necessary but not sufficient to do fundamental work. The people here from the investment field are probably all fundamentalists. We do special situation work, we are trying to determine what is the real corporate value of companies which we are analyzing or buying. We attempt to analyse cash flows and/or redundant assets, and then putting some kind of capitalization rate on that growth. So it is important for us to look at what we think is real generation of cash flows; for that, you need historical data but also a lot of judgment work. Once we determine what value is, we attempt to find whether the company agrees with us in realizing value. A lot of the value comes out because corporate activity occurs, not because the stock market goes up or down, but because someone internally realizes that values in a real world are substantially higher over time than what the price is in the marketplace. [Also included in 1(b) and 1(c)] [TI 10/16, p. 5]
Participant I-9
We have about $20 billion under management and a research department of about 7 or 8 people. It used to be that an institution of that size would have about 30 analysts; those days are over. Which means that the job of the financial reporting community has become more important; the analysts cannot know the industries in the same depth they did before. We never make an investment unless we have audited financial statements of the company and we don't make an investment unless we meet the management of the company. Our approach is fundamental; the valuation starts with the financial statements and then our projections going forward, based on what management tells me and what we see in the trends of the company. The other aspects are psychology and momentum; the accounting profession cannot help us with that. Sometimes, we rely heavily on the information provided in financial statements, at other times that's not what is going to lead us to make the right investment decision. [Also included in 1(b) and 1(c)] [TI 10/16, p. 5-6]
Participant I-2
Other approaches include the momentum approach, which is an effort to track changes in opinion when earnings are consistently cut, for example; if you have one earnings cut, you probably will have two or three. That's an example of the momentum approach. There is also the black box approach, used by a number of major institutions, which is a combination of momentum, screens, price to book, etc. You put the numbers in and you get a ranking out. You also have the sector weight approach, used by some major institutions to manage their funds, where you put more weigth on favorable sectors and less on unfavorable ones. It is a subtle way to hedge your bet without getting too far off the indexes. [TI 10/16, p. 6]
Your client base in accounting is dealing with a dynamic system, not only with changes in the economy, but also the secular changes. For example, the accounting opinion on inflation years ago; it turns out it was so difficult that it ended up not being terribly useful. For the last five or six years, we're seeing companies doing things we never thought they could: massive layoffs, wage givebacks, etc. As a fundamental analyst, you need the ability to get inside the company and understand what makes it tick. So you want to understand sources of cash flow and how the business works (and that on a quarterly basis). What if scenarios are very important to us; we need the detailed information to do those "what if" exercises because it is a very important element of our job. [Also partly included in 1(b)] [TI 10/16, p. 6-7]
Committee/Staff/Observer
The second question relates to only the fundamental approach to investment. The meeting materials identified 5 methods of determining the intrinsic value of a security or a company:
* Apply a multiple to predicted earnings
* Discount predicted cash flows
* Discount predictions of future dividends
* Discount predicted earnings
* Or some combination of the four or some other approaches as well. [TI 10/16, p. 7]
The question is: How do investors determine the intrinsic value of an equity security and the underlying company? Please try to touch on some details for us like: how far into the future do you predict cash flows, earnings, dividends? [TI 10/16, p. 7]
Participant I-10
We all know we are severely limited on how far we can look into the future. When you visit companies and go through their own plans and their own views of themselves, you normally get 3, 4, 5 year plans; to some extent, we are tied to that time period. Studies have shown that if you can project earnings for a period of five years, you are way ahead of most stock pickers and you will do very well with no other information. So, something like 3 to 5 years is probably reasonable for what we are trying to do. Sometimes, you are more secure in your 5 or 3 year projection than you are in your 1 year projection. We are in the business of making judgments about where earnings are likely to be in the next number of years, and the quality of those earnings. It is a very complicated process and I would guess that we are not making projections for 10 or 20 years. [Also included in 1(c)] [TI 10/16, p. 7-8]
Participant I-8
Earnings is the starting point. But there is another layer which is the external setting (how the company is perceived). [Also included in 1(b)] [TI 10/16, p. 8]
Participant I-7
As far of our organization is concerned, we are required to have an estimate for the current quarter, the current year, the following year, and a percentage number for the subsequent five years. [Also included in 1(c)] [TI 10/16, p. 8]
Participant I-6
Earnings are the common denominator, much more than cash flow. But I don't want to dismiss the importance of cash flow. You can't forecast cash flow without forecasting earnings. For an analyst, some industries' cash flow is much more critical than earnings. Other industries' cash flow is important but that's not the common denominator. In the marketplace, most people talk about P/E ratio, not cash flow multiples. And in many of the discussions with portfolio managers who focused on cash flow, not more than half a dozen agree on the definition of cash flow. Until we get a standardized definition of cash flow, we are deceiving ourselves in some respect to say that we can look at a cash flow statement and come up with a meaningful number. Cash flow is an important number in fundamental analysis, but it comes after the earnings. [Also included in 1(b)] [TI 10/16, p. 8]
Participant I-8
The emphasis on cash flows has to be there. If you're looking at a company which is going to be a growth company, you're looking to see whether there is sufficient cash generated to finance that rate of growth or whether the company will have to do something to supplement its cash flows. By and large, in the analytical and portfolio management community, the emphasis is on near-term earnings. So there is a greater forecasting efficiency in that timeframe and a lot less efficiency when you try to look out 2 or 3 years. I always try to operate in the area when there is the least amount of efficiency because that's where the greatest opportunity is. [TI 10/16, p. 9]
Committee/Staff/Observer
I haven't heard anybody say that they discount predictions of future dividends to arrive at the intrinsic value. Am I correct in dismissing that approach? [TI 10/16, p. 9]
Participant I-2
Some institutions use that strictly. [TI 10/16, p. 9]
Participant I-12
I think people combine methodologies; discounted dividend model, discounted earnings model, discounted cash flows, and see what the different valuations might be. [TI 10/16, p. 9]
Participant I-3
Different methodologies are applicable to different types of industry. I cover a very cyclical industry; I couldn't tell you what dividends will be next year, let alone in 20 years. You have to have a reasonable period of time if you use a dividend discount model. Some industries, it used to be true of electric utilities, were fairly predictable and may be the dividend discount approach was applicable there. [TI 10/16, p. 9]
We have to draw a distinction between valuing an entity, what a company is worth, versus valuing its equity. Those of us involved in the investment community are in the business of valuing what an equity is worth. It may be substantially different, including well overvalued, from what the entity is worth. [TI 10/16, p. 9-10]
I don't focus a lot on what the low side of valuation might be because, in the highly cyclical industry that I cover, the market will determine that. I am not interested to know, as share prices of specific companies are falling, where the exact bottom will be; the market will figure that. What I am interested in figuring out is where the bottoming point and turning point upward will be, based upon macro economic indicators and industry fundamentals and then try to identify companies that are postured well enough and whose equities are substantially undervalued. I often look 12 to 18 months but the investment threshold of investors is getting shorter and shorter. [TI 10/16, p. 10]
Committee/Staff/Observer
We are touching on question 3. Two of us met individually with a total of about 20 sell-side analysts for about 45 minutes. After those meetings, we compared notes, and we noticed that all the analysts were predicting for 6 to 18 months. Yet, all of the analysts described their approach as the fundamental approach. We didn't hear anything about a 5 year horizon. The meeting materials identify 4 possible reasons for the extreme focus on short-term earnings. Our question is: do analysts focus that much only on short term earnings and, if so, why? [TI 10/16, p. 10]
Participant I-9
About half our business is wealthy individuals and the other half is corporate pension plans. For wealthy individuals, our job is to identify the very good growth stock for 3, 5, 10 years: the [names deleted]. We don't want to sell those stocks because if you end up paying 35% tax, and you have a company that grows at 20%, you only have a 13% return. You're far better having a company you can compound out for your clients, and it's self-serving for our business because we get a fee on those deferred taxes that aren't paid. So we will estimate for 1 year of earnings. Then we stop at 3 to 4 years out in terms of making projections because I don't have any confidence beyond that range. This is partly due to my background. At one point, I was a utility analyst; two-thirds of my current year's numbers came within a penny of my estimates. My 3 to 4 years numbers were so bad because interest rate changed (and the economy, and the president) and you started with more information in utilities going into the interview with an industrial company than you come out of. We don't use the discounted cash flow method because it is projecting out one number and then discounting by another number. [TI 10/16, p. 10- 11]
Participant I-10
In many of the papers that come into our office every day, you will find a column showing secular growth rates, trend line growth rates. This is not earnings next year, 18 months, 2 years, but an attempt to deal with what that analyst believes is a sustainable secular trend. It is normally based on the rate to which capital is being reinvested in business. There is an attempt in that to deal with the longer term dynamics of a particular business. The shorter the time period, the less important it is to have that information. In other words, if you look at a three month period with perfect forecasting, you will not have much of an edge in the market. So the question is why are people spending 95% of their time trying to predict next quarter's earnings when, even if I gave it to you perfectly and you have a large portfolio to manage, it would be of no benefit to you. [Also included in 11(e)] [TI 10/16, p. 11]
Participant I-6
Why so much emphasis on short-term earnings? Because my clients want short-term earnings, clearly less than 1 year. [Also included in 11(e)] [TI 10/16, p. 11]
Participant I-12
There is a business imperative on the sell-side called trading volume. On the other hand, it serves a worthwhile purpose as an early warning system. There is a wide array of investors out there; those with one year horizon, those with 20 year horizons. The [name deleted] on one hand and the short-term black box traders on the other. The early warning system on earnings 90% of the time doesn't mean anything, but when there is an earnings shortfall or a coming shortfall, that's where Wall Street gets its competitive advantage. So there are a lot of reasons for the short-term system but the balance may have swayed too far in that direction. [Also included in 11(e)] [TI 10/16, p. 11]
Participant I-4
We do small capitalization-type investing. Our clients are very cognizant of quarterly earnings and volatility on quarterly basis. We have never lost a client because of quarterly numbers. Even though they may talk about short-term earnings, I don't believe they really focus on them to the extent we hear about all the time. The only way we lose accounts is to do something that you say you won't do, to change or lose your discipline. We have 15-25% turnover a year in our portfolios and that makes us very long term in the sense of how people view us. Our clients don't necessarily penalize us if we have a bad quarter. [Also included in 11(e)] [TI 10/16, p. 12]
Participant I-11
In our firm, we make detail models 4 to 8 quarters out and we have a 3 to 5 year trendline growth expectation related to expected ROE. Beyond 3 to 5 years, there are so many exogenous factors that affect the economy and business that you're kidding yourself if you think you know what is going to happen further out. [Also included in 1(c)] [TI 10/16, p. 13]
Committee/Staff/Observer
One last question in the area of investors' objectives. As background, several accounting standard-setting bodies around the world have addressed that question and canonized their conclusions in their conceptual frameworks. To our knowledge, each of those frameworks state that from an investor's perspective, the purpose of financial reporting is to help investors predict the amount and timing and assess the uncertainty of a company's future cash flows. Do you agree or disagree? [TI 10/16, p. 14]
Participant I-11
Conceptually, that is clearly true. Functionally, that is a meaningless statement. Earnings could be and should be a handy proxy for the increasing net worth of a business. That has to be tempered by the quality of earnings, by cash flow considerations, and so on. Most of us look a lot harder at earnings than we do at cash flow. [TI 10/16, p. 14]
Participant I-6
I use cash flow but I don't find it as convenient to arrive at than others do. I find that the statement that accounting bodies around the world try to issue standards that make easier to get cash flows is in contradiction with reality. Look at FAS 106 where another noncash item is being buried in the income statement and the cash flow statement. So accounting bodies themselves are adding disclosures and accounting practices that are in conflict with the concepts. [TI 10/16, p. 14]
Participant I-9
I don't think cash flow is that relevant to us; we look at earnings and earnings growth rate. For start-up companies, cash flow is important because you want to see if they have enough money to do their thing. At the other end of the bell curve, you have problem companies; cash flow is terribly important there. I think it would be helpful to have a cash flow statement over a 5 year period to see if the company is putting all its cash flows in inventories when the sales are going no place, and it is telling to determine whether a company is going to get in trouble. [TI 10/16, p. 14]
Participant I-2
I think cash flow is absolutely key. The income statement gives you a number you can talk to your clients about but the health of the business is cash flow. In the case of one company I have followed over a number of years, they have bank lines which mature every 5 or 6 years. Invariably, they mature during a very poor economic environment and they have to raise equity at the absolute bottom of the market. Cash flow tells you when and how much cash these companies will have to raise. [TI 10/16, p. 15]
Another thing that cash flow tells you is when a company looks healthy on the bottom line but there is no cash flow behind it. I think cash flow is absolutely the lifeblood of the company. For different industries it is going to vary; for my industry (steel) it is absolutely key. For others, it might not be a factor. [TI 10/16, p. 15]
Participant I-1
In our firm, we are involved with both the public markets and the private markets and so that gives us a strong cash flow emphasis. When you're looking at cash flow versus earnings, it's a chicken or an egg. It's a question of whether you're going to add something back or deduct it out. The problem with earnings is that you can make them appear what you want them to be. [TI 10/16, p. 15]
There is an issue as to the definition of cash flow. You don't necessarily need a regulatory definition of cash flow as long as two people sitting across a table define the term for themselves. [TI 10/16, p. 15]
It's important to see where a company is reinvesting cash flow. Cash flow is most important, particularly when you analyze private market companies. [TI 10/16, p. 15]
Participant I-12
What most of us do is trying to figure out what is the value of a business and this is a function of the balance sheet assets plus changes in those assets as a result of business activities. Cash flow is probably the more critical determinant of the change in the value of the assets, but I think earnings is an equally valid measure of the change in assets. [TI 10/16, p. 15]
The purpose of external reporting is to give some basis to look at the value of a company today and a basis to look in the change and potential change in that value. [Also included in 1(b)] [TI 10/16, p. 16]
Participant I-5
In theory, earnings is almost supposed to be what cash flow is for a company. Earnings was designed, and depreciation and noncash charges were put in there, to tell you what the sustainable level of money coming out of this business would be if you didn't reinvest anything incrementally. When you're looking at an income statement leading into a cash flow statement, what you're trying to do is take out the pieces that aren't real in terms of cost or benefits. For example, amortization of goodwill is not a recurring cost in any economic sense. The distinction between the two is trying to get to the right level of what should be called earnings. But because of our accounting rules, earnings are not always really earnings and that's why today we get into discussing agressively what is cash flow. [TI 10/16, p. 16]
Participant I-8
There are just as much adjustments to cash flow numbers or analysis of cash flow numbers as there are if you're looking at earnings. I believe cash flow is more important. When I do a cash flow analysis, I have my own form of abbreviated cash flow statement and I take out nonrecurring items or things that I can't possibly predict. Then I get to a number that is deducted from or added to working capital. Once you get into working capital, there is no way I can predict how management is going to change working capital. Therefore, I would like to see more discussion about, for example, the level of inventory relative to sales and, if they built inventory, why? [Also included in 13] [TI 10/16, p. 16]
Participant I-2
Net income is necessary but not sufficient. The cash flow tells the story of how a company is changing. A company who has a very agressive capital spending program and not the balance sheet to substantiate it is going to get into real problem. In basic industries, cash flow is imperative. [TI 10/16, p. 16]
[Context] Meeting of the Investor Discussion Group on October 16, 1992. When asked about the types of information investors use to achieve their objectives, participant I-1 provided more information about his objectives and approach to evaluating equity securities.
Participant I-1
Our approach is starting with the basic 12-page due diligence list, recognizing that you only get half a page of that out of conventional external reporting. The rest of it is digging the information around. A good part of what is on your list has to be obtained from non-external reporting sources; for example, talking to customers and suppliers. You may not get some information from the company you're talking to, so you have to go around it. In other cases, you may have tremendous concentration in the customer base and that may not be evident from the external reporting (although the footnotes may give some concentration disclosures but not as much as we would like). Probably 80% of the information you need has to be obtained either away from the company or have the company sit down and have a candid conversation with you. There is disparity in what a company will tell people. We tend to focus on midcap-type of companies which generally enjoy the opportunity to sit down and talk a lot, compared to the Fortune 1000 where it's more institutionalized. Even within those companies, they migth tell person A something different than what they tell person B. So there is a tremendous amount of variability in the other types of information that is disseminated. [Also included in 1(b)] [TI 10/16, p. 17-18]
[Context] Responses to the postmeeting questionnaire to the October 16, 1992 Investor Discussion Group meeting.
QUESTION 3
a. Please rank in importance the following explanations of why analysts focus on predicting short-term earnings. Please indicate your responses by numbering the following explanations. The number 1 indicates the highest priority, larger numbers indicate progressively lower priority. Use a number only once. Please do not number any explanation that you believe does not apply.
They believe that the market price of equity securities over the next 6 to 24 months will be a function of earnings reported for that period. Thus, predictions of near-term earnings enables predictions of market prices of a company's stock in the near term. Ranking Number of Responses 1 6 2 2 5 1 Average Ranking 1.67 Predicting near-term earnings provides an organized way for the analyst to understand the company's business and the environment in which it operates. Ranking Number of Responses 3 1 5 3 6 2 7 1 Not applicable 2 Average Ranking 6.11 They believe that earnings in the short term is often a good predictor of long-term earnings. Ranking Number of Responses 2 1 4 3 8 2 Not applicable 3 Average Ranking 6.33 Predicting near-term earnings and understanding the reasons why the company's actual performance differed from predicted performance provides early detection of changes affecting the company relative to expectations. Ranking Number of Responses 2 3 3 3 4 1 5 1 7 1 Average Ranking 3.44 Predictions of longer-term earnings are not sufficiently reliable to be helpful. Ranking Number of Responses 4 2 5 1 6 2 7 1 Not applicable 3 Average Ranking 6.56 Portfolio managers and other customers demand predictions of near-term earnings. Ranking Number of Responses 1 2 2 1 3 2 4 2 6 1 7 1 Average Ranking 3.44 A track record of accurate predictions of short-term earnings demonstrates the analyst's competence and industry knowledge and builds credibility for the analyst's recommendations. Ranking Number of Responses 3 1 5 2 6 2 8 1 Not applicable 3 Average Ranking 6.67 Sell-side analysts focus on predicting near-term earnings in part to give the sales force material that helps them sell securities to their customers. Ranking Number of Responses 1 1 2 1 3 1 5 1 7 3 Not applicable 2 Average Ranking 5.56 Summary of Rankings Average Ranking 1.67 They believe that the market price of equity securities over the next 6 to 24 months will be a function of earnings reported for that period. Thus, predictions of near-term earnings enables predictions of market prices of a company's stock in the near term. 3.44 Portfolio managers and other customers demand predictions of near-term earnings. 3.44 Predicting near-term earnings and understanding the reasons why the company's actual performance differed from predicted performance provides early detection of changes affecting the company relative to expectations. 5.56 Sell-side analysts focus on predicting near-term earnings in part to give the sales force material that helps them sell securities to their customers. 6.11 Predicting near-term earnings provides an organized way for the analyst to understand the company's business and the environment in which it operates. 6.33 They believe that earnings in the short term is often a good predictor of long-term earnings. 6.56 Predictions of longer-term earnings are not sufficiently reliable to be helpful. 6.67 A track record of accurate predictions of short-term earnings demonstrates the analyst's competence and industry knowledge and builds credibility for the analyst's recommendations. Other explanation Participant I-17 Put simply, people (analysts in this case) do what they think is important to do based on what the market thinks is important Increasingly, the market has indicated that near term earnings are important (one of the best indicators of performance has been whether consensus estimates are rising or falling). So the analyst must respond to this--especially by avoiding earnings "disappointments." Participant I-9 Short-term earnings reports that deviate from consensus can cause sharp stock price fluctuations in either direction. A deviation in quarterly results from expectations causes an analyst to re-examine and often revise intermediate growth forecasts. Deviation are sometimes a reflection of management's honesty and/or changing competitive situation. Participant I-11 I did not rank "analyst's competence" because I believe only the obverse is true. A consistently bad track record damages credibility. I did not rank "sales Material" because I believe it is just another way of expressing "customer demand." While I rank-ordered the other items, I believe all are nearly equally important. b. Please rank in importance the following explanations of why analysts focus on predicting earnings rather than cash flows. Please indicate your responses by numbering the following explanations. The number 1 indicates the highest priority, larger numbers indicate progressively lower priority. Use a number only once. Please do not number any explanation that you believe does not apply. They believe that the future market price of equity securities will be more correlated with reported earnings than with reported cash flows. Thus, predictions of earnings better enables predictions of market prices of a company's stock than do predictions of cash flows. Ranking Number of Responses 1 5 2 1 4 1 6 1 Not applicable 1 Average Ranking 2.89 Earnings is often a good predictor of longer-term cash flows. Ranking Number of Responses 2 1 3 2 5 1 6 2 7 1 Not applicable 2 Average Ranking 5.56 Analysts can predict earnings with greater accuracy than cash flows. Ranking Number of Responses 4 2 5 1 Not applicable 6 Average Ranking 7.44 Predicting earnings is the first step in predicting cash flows . Ranking Number of Responses 2 6 4 1 Not applicable 2 Average Ranking 3.78 Whether an analyst predicts earnings or cash flows depends on the industry and the circumstances facing the company. Analysts will predict earnings when earnings are a good predictor of long-term cash flows. On the other hand, analysts will predict future cash flows in those circumstances when earnings are not good predictors of cash flows. Ranking Number of Responses 1 1 2 1 3 3 4 2 5 2 Average Ranking 3.33 Portfolio managers and other customers demand predictions of earnings and not cash flows. Ranking Number of Responses 1 2 3 5 5 1 Not applicable 1 Average Ranking 3.44 Other 1 Participant I-12: Earnings as reported are the only common denominator that everyone can independently verify. It is also the number that appears on the broad tape for everyone to see. After the fact, analysts refer to "core" earnings by explaining their own individual adjustments to reported earnings ( and everyone makes different adjustments!) Summary of Rankings Average Ranking 2.89 They believe that the future market price of equity securities will be more correlated with reported earnings than with reported cash flows. Thus, predictions of earnings better enables predictions of market prices of a company's stock than do predictions of cash flows. 3.33 Whether an analyst predicts earnings or cash flows depends on the industry and the circumstances facing the company. Analysts will predict earnings when earnings are a good predictor of long-term cash flows. On the other hand, analysts will predict future cash flows in those circumstances when earnings are not good predictors of cash flows. 3.44 Portfolio managers and other customers demand predictions of earnings and not cash flows. 3.78 Predicting earnings is the first step in predicting cash flows . 5.56 Earnings is often a good predictor of longer-term cash flows. 7.44 Analysts can predict earnings with greater accuracy than cash flows. [PMQI 10/16, p. 8-13]
[Context] Meeting of the Investor Discussion Group on March 17, 1993. Part of the meeting was devoted to the topic of conservatism. During the discussion, an investor made a comment on his objectives.
Participant I-16
Our job is to put a value on an enterprise, not to make sure that a company won't go out of business; that's not what investors are trying to do. Conservatism is putting a floor estimate on the company's earnings, cash flows, and value. It's highly unlikely that the true value is below that number. For most purposes, that would not be a useful number because most people using financial statements are not trying to come up with a floor number. Most of us are trying to get to a realistic estimate of value and efficient capital markets require that. [Also included in 2(b)] [TI 3/17, p. 31]
[Context] Meeting of the Creditor Discussion Group on December 8, 1992. Part of the meeting was devoted to the objectives and approaches used by creditors.
Committee/Staff/Observer
The first question has to do with the objectives of creditors as they look at financial information. The basic objective of creditors can be articulated as follows: to assess the ability of a borrower to meet the obligations related to a specific debt instrument through timely payment of principal and interest or, as a last resort, through transfer of a collateralized asset. Do you agree with that characterization, and if you don't, how would you modify it to better describe what a creditor does? [TC 12/8, p. 1]
Participant C-1
I would say it's not a specific debt instrument, but debt instruments. And I would add also that it's not just the timely payment of principal and interest, but also the ability of the company to meet financial covenants which senior lending institutions are setting. [TC 12/8, p. 1]
Participant C-2
Knowing how difficult sometimes it is to develop definitions that work in all kinds of situations, I thought it was a pretty good definition. Again, there are some other things we do that in a way could be encompassed here. Structure was one comment that you might say is indirectly encompassed in these words; also trying to assess future borrowing needs so that you know whether or not you want to enter into a relationship and make the one specific loan. Finally, I think assessing long term viability is a going concern. You might say all of that is encompassed in these words because in assessing the ability to meet a specific instrument, maybe you are looking at all of those concepts. [TC 12/8, p. 1-2]
Participant C-3
I just thought that the concept of debt instrument maybe needed to be broadened to financial instrument to include any potential off balance sheet implications. [TC 12/8, p. 2]
Participant C-4
I was also of the opinion that the definition limits it to a fixed income instrument, and I think we should say something about assessing the ability to continue as a going concern. In my line of business, we are more interested in not only the debt instrument, but the ability of the company to handle increases or decreases in revenue or backlog. [TC 12/8, p. 2]
Participant C-5
I think the concept of customer viability is really the one that you need to get into the definition. Timely payment is also somewhat narrow; it's timely or viable alternative to timely payment. [TC 12/8, p. 2]
Participant C-6
In dealing with privately-held companies, understanding management's and owner's objectives as far as how it relates to the financial statements is also an objective. In those companies, there are adjustments and expenses in financial statements that need to be fully understood by the credit granter to get a better handle on what the numbers actually mean. [TC 12/8, p. 2]
Participant C-7
On the objectives, we felt the focus was too narrow just dealing with a specific debt instrument. As a bank we may be secure on a specific loan, but trade credit could push a customer into bankruptcy, substantially increasing our administration costs and diminishing our profitability. So I think the notion of viability for all groups is an issue. [TC 12/8, p. 2- 3]
Participant C-8
We also felt that the definition, focusing on debt instrument, was too narrow. In the surety bond business, we assess the company's ability to perform the underlying obligation that we have bonded. But part of that review is also to make sure the company can service all of its debt, and that should be included in the definition. [TC 12/8, p. 3]
Participant C-9
As an analyst I'm involved in trying to assess the ongoing concern and financial strength of the company in relation to the secondary trading of its debt. So I'm not looking only at the payment, but at the perception of the credit at a given point in time to determine the buyers and sellers, and what price a credit may trade at that point in time. So, I see it as an opening continuum. [TC 12/8, p. 3]
Committee/Staff/Observer
Can you contrast with what [participant C-6] was talking about, that is, where you're making the initial decision on whether you're going to work with these folks or not. I would assume that for [participant C-6], it's also an ongoing concern, too? [TC 12/8, p. 3]
Participant C-6
Yes. [TC 12/8, p. 3]
Participant C-9
Well, I don't know what [participant C-6]'s involved in. It sounds as if he's more a long-term investor or creditor, whereas on a trading situation I may be a short-term holder. [TC 12/8, p. 3]
Committee/Staff/Observer
Does that mean that there might be a buy-sell side difference in view here? If you'll let me temporarily narrow the view to debt instruments solely for purposes of that question, is there a buy side view versus a sell side view that gives you different interests? [TC 12/8, p. 3- 4]
Participant C-10
There are different types of buy side people; for example, short-term trading oriented buy side houses, and there are long-term holders. So I think she was describing more of the short- term trading view, but I'm not sure you can say that there are differences between the buy and the sell side. [TC 12/8, p. 4]
Participant C-9
I'm still interested in the long-term health of the company and the investment prospects. [TC 12/8, p. 4]
Participant C-1
But I think one of the things this definition leaves out which is very important to us is not a collateralized asset, but the asset value of the company as an ongoing concern. The times that we purchase securities or lend money where we're secured you could count on a hand. We're looking at overall corporate valuation as either an ongoing concern, or else as a breakup. The concept of trading is critical to us in terms of the ability as a mutual fund to mark our securities to market, or even in the private accounts to mark those securities to market on either a daily or a monthly basis. [TC 12/8, p. 4]
Participant C-5
We rely very little on the financial statement as a basis for evaluating collateralized assets. We clearly use alternative sources. We're not satisfied with the ability to make those determinations based on the financial statements. We look at business valuation and customer viability based on financial statements, but banks have traditionally developed other systems for collateral valuation. So, if assessing payment through collateral is part of the definition of what our objective is, it is one of ours, but is it an objective that is satisfied or could be satisfied by the financial statements, that's more of a question. [Also included in 1(b)] [TC 12/8, p. 4]
Participant C-10
During 1990 when things were so bad in the high yield market, everybody was valuing their debt instruments based on the company value; before that, valuations were based on one time or two times coverage of interest. The point is that we went quickly in one type of valuation through about two different successive steps, and then to a fourth level of valuation in that period when the market was collapsing on us. Now, we're back to more of the normal valuation methods at this point. So my point is we look at all the financial instruments, but we sometimes change the way we look at them at different periods of time. [TC 12/8, p. 5]
Committee/Staff/Observer
If in a crunch time you were looking at market values, why would you then go away from that? Why would you then go back to other measures? [TC 12/8, p. 5]
Participant C-10
I don't have a good answer for you, but I think it's because the market in effect has gone back there. The market is buying and selling based on the cash flow coverage rate. [TC 12/8, p. 5]
Participant C-1
We haven't forgotten what happened in the late 1980s, but we've matured as a market and are back up to being a little bit more realistic in terms of cash flow coverage than we were in the 1980s, and are now looking at companies with two times coverage, or 1.5 times coverage after capex, etc. So it's not that we forgot it, it's just that the shift was made, we've gotten rid of a lot of the companies that we valued on a mass basis, and we're now looking again at coverage numbers. [TC 12/8, p. 5]
Participant C-5
The dilemma that's being expressed is that price and value are the same at any point in time, but price and value are different. I don't believe the markets have actually woken up to that. There is continually this dilemma of trying to chase price and claiming that's value. I think the accounting profession has to be careful because they're following, and they're getting into this same chase. [Also included in 4] [TC 12/8, p. 5-6]
Committee/Staff/Observer
Can you identify some of the accounting that you think is chasing that incorrectly? [Also included in 4] [TC 12/8, p. 6]
Participant C-5
Well, mark to market obviously. [Also included in 4] [TC 12/8, p. 6]
Committee/Staff/Observer
[Participant C-5], are the implications of that the same whether it's a debt instrument or whether it's an equity instrument? [Also included in 4] [TC 12/8, p. 6]
Participant C-5
Yes. We see this particularly in real estate, more so right now than even in commercial credit. I think some sanity has returned to the commercial markets, but right now we are claiming that real estate value is in fact real estate price, and we are particularly troubled because we can see a tremendous disequilibrium. Risk of decline has been removed from that market, the discounts required in that market are still substantial. We basically are selling properties at 12 times cash on cash, or 12% cap rates, or eight times cash on cash yields with a relatively locked in income stream. We can see the disequilibrium, and we just don't know when the balance will come back, but that's the whole game of investing debt or equity. [Also included in 4] [TC 12/8, p. 6]
Committee/Staff/Observer
I would have thought the significance of that might vary whether you're talking about real estate, whether you're talking about an equity instrument, or whether you're talking about a debt instrument, depending on where it sits in a liquidation priority. [Also included in 4] [TC 12/8, p. 6]
Participant C-5
Well, that's true. As you come closer to the question of customer viability, then liquidation and price risk becomes particularly relevant. But as you move away from that, it becomes less relevant. The lower you get on the debt structure, the more you look like equity, and so the closer you are, the more it becomes important. [Also included in 4] [TC 12/8, p. 7]
Participant C-6
I think the real estate example you were giving is of a specific property. So that's really a security, a very specific thing, whereas I think most of the earlier discussion we were having related to companies. [TC 12/8, p. 7]
Participant C-5
Companies are the same thing. [TC 12/8, p. 7]
Participant C-6
Yes, but companies are broader and that's where the accounting gets more involved. Whereas in a real estate specific loan, you're dealing with that specific property, and the cash flow out of that property, not so much of an accounting issue. [TC 12/8, p. 7]
Committee/Staff/Observer
Question two. There is a set of propositions on what accountants believe to be the purpose of external reporting that are on bullets on page 8 of the meeting materials. The statement above those bullets talks about external reporting principally being there to help investors and creditors predict the amount, timing, and assess the uncertainty of companies' future cash flows, and that statement ties in some propositions. They include:
* First, that credit decisions are rational, and that the creditors expect to receive a return usually in cash.
* Second, that the prospects depend significantly on a company's own ability to bring in more cash than it spends on resources.
* Then, in assessing the amount of time and uncertainty you have to look at prospective cash flows. [TC 12/8, p. 7-8]
I'll skip the fourth bullet, I think it's fairly obvious that you need to know about assets, liabilities, revenues, and expenses, and go to the fifth, which I would call your attention to carefully. [TC 12/8, p. 8]
Since the first argument was that the amounts, timing, and uncertainty of cash flows is what this may be all about, the proposition is whether or not earnings measured on an accrual accounting basis are actually a better indicator of those future cash flows than cash flows themselves on an historical basis. The proposition being that historical cash flows tell us what has happened, but don't give us major indications of what will happen on the basis of how the money has already been spent, and that maybe accrual accounting does that better. So, with those things in mind, we'd like your comments on whether or not those propositions, particularly the last one, are ones that you think are what accounting is all about if in fact accounting for your purposes is to look at the amount, timing, and uncertainty of future cash flows. [TC 12/8, p. 8]
Participant C-4
I would think the analysts for [companies that have recently failed] would probably disagree with it. I think while the operating cash flow in any one year may show some volatility, operating cash flow analyzed over time or free cash flow analyzed over time is a much better assessment of the company's ability to meet future cash obligations than accrual accounting. [TC 12/8, p. 8]
Participant C-11
I am very disturbed by the last bullet point. I don't personally think that there is one way to do your analysis, that cash flow, per se, is the only way to go, or that accrual accounting is the only way to go. The way that you analyze a company is going to vary depending on the business that you're dealing with, and all kinds of different things. Often, you will be using both kinds of approaches, or want to have an accrual, or want to look at good, pure cash flow. So I think that bullet point, number five, really gets us way off the track. [Also included in 1(c)] [TC 12/8, p. 9]
I'd also say, with regard to all of the bullets in thinking about this, that there is something missing, which is more balance sheet related items. I happen to be more emphasizing in my own work on analysis of financial intermediaries, and an extremely important thing that you analyze is the trend of various loans or investments or deposits, or whatever the items may be. This seems to be missing from all of the elements here. Your trend analysis of various balance sheet items is just as important as the trend analysis of revenues or costs. The emphasis on balance sheet items also gets me into a discussion of mark to market in the sense that if you mark to market your financial statements, number one, you lose all those trends, but also you are departing from cash in the sense that your loans and investments after all do end up getting paid at a stated amount at some maturity date. And so for several reasons I think that the accrual and cash accounting tables and analysis are both important, and then secondly I think the balance sheet has to be brought into a lot more focus on these bullets. [Also included in 1(c) and 4] [TC 12/8, p. 9]
Participant C-12
I had a comment more on the other side of the balance sheet, focusing on the second and third bullets. Looking at cash flow is nice; I look mainly at financial institutions, as well. I think what's important is to know what is the ability to maintain the capital structure? I think that comes back to the idea of long-term viability of a company. Also what happens if they don't? What's the next increment down if some source of funding disappears? [TC 12/8, p. 9]
Participant C-2
I also found this very disturbing, and it sounded to me as if it were not written by a user of financial statements for the purpose of credit granting. Because it does seem to me that you really have to understand both the accrual cycle and the cash flow cycle, and how they move in relationship to each other over time. And you cannot exclude one or favor one over another and make any kind of informed judgment. So I thought it was very disturbing, and I do think that past trends can be a very good indicator of what will happen in the future. [TC 12/8, p. 10]
Participant C-14
I think I'm in agreement with everybody on what's being said here. [Participant C-12] has an excellent point, which I would have made also, which is that bullet two assumes the entity earns more cash than it spends on resources. But today what's truly realistic is that companies refinance a lot of their obligations. So I would have reworded bullet point three to say external reporting provides information assessing companies prospective cash flows from operations as well as its ability to continue to access the capital markets. My thinking is not far enough advanced yet in terms of how accounting information can help with that, but it may be through the footnotes where really we're finding all the valuable information these days. [TC 12/8, p. 10]
I also want to say I'm in agreement with [participant C-11] also in that while we focus on cash in our analysis, we'll look at accrual accounting to see if the company is able to recover its costs and its pricing. And that's important, but when you start to make projections, that isn't always helpful in your projections. In your projections you start looking at, rather than depreciation on the assets that are currently on the balance sheet, you're looking at what the company is spending on new assets, and that's a better gauge by which to look at future cash flows. Accrual accounting to me seems to be a much more balance sheet kind of approach, and I'm not sure that that really ties in with projecting future cash flows very well. [Also included in 1(c)] [TC 12/8, p. 10]
Participant C-9
In looking at external reporting for financial institutions, one of the things that I've needed to look at over the last several years is obviously the asset quality. And clearly the issues that we look at change over time. A decade ago liquidity was the most important thing. But asset quality is what we've been looking at now, and I think we're probably moving into an era where liquidity will become the foremost issue. [TC 12/8, p. 11]
But on asset quality what I need to know from external reporting is balance sheet information on what the composition of loans is, what the quality is, and interestingly, if the quality is not good, then we're looking at a non-cash charge to reserves. So, a lot of what I'm looking at is not even cash, but it's an assessment of the ongoing concern elements, the judgment of management and the businesses that they are operating, the judgment of the credit underwriters. [TC 12/8, p. 11]
Participant C-6
Just to pick up a little bit on what [participant C-9] said, but from a different point of view, looking at, again, privately-held companies, which is what we deal with. We look at granting credit in a very traditional way, looking at historical information. We don't place a lot of faith on projections, and we look at a very traditional aspect of cash flow: profitability. As far as asset value, we place a fair amount of emphasis on asset value, meaning the primary assets of the companies that we deal with (accounts receivable and inventory) and knowing what those assets comprise of, and what the quality of those assets are, which is of utmost importance to us. [Also included in 1(b) and 4] [TC 12/8, p. 11-12]
Participant C-1
One of the problems that we run into between accrual accounting and cash accounting is that accrual accounting now has become so complex, with all the new accounting standards that have been coming out, that it's becoming very difficult for us to go from accrual accounting back to cash accounting. And most of the companies that we see, and most of the bankruptcies that we've worked on, have had very nice income statements, very nice balance sheets, but the problem is that they run out of liquidity. We look more and more at the income statement, the cash flow statement, and the current accounts or the current part of the balance sheet in order to determine liquidity. [Also included in 2(d)] [TC 12/8, p. 12]
The other problem we have is that each of the different forms of public information you have all have different information. It's very difficult to go from a proxy statement or from a 10K to a 10Q, and to go back. So the seasonality of cash flow--and that's what really we've found has tripped up most companies is the seasonality of cash flow--is important, but also sometimes very difficult to go back and forth between. [Also included in 1(b) and 2(d)] [TC 12/8, p. 12]
Participant C-13
If you want to think about the difference between cash and accrual accounting, the classic example is a life insurance company where the better the premium income is, the less the cash flow is. No investor in a life insurance company doesn't look very carefully at the statutory statements and compare them with the GAAP statements. It's just the classic example of the need for both statements that [participant C-11] talked about. [TC 12/8, p. 12]
Participant C-2
I have one point, and perhaps I was reading the second bullet too narrowly, but we also do a fair amount of lending to non-profits and to government entities, and I think in some cases it's very acceptable to try to just have as much cash come in as you spend in resources, and look to other areas of funding such as endowments, and so forth. It was just a point that there are other types of entities that are worthy of receiving funds. [TC 12/8, p. 13]
Committee/Staff/Observer
Questions 3. To what extent , if any, do you consider the entrenched intrinsic value of a company as you think about credit? We have a mirror group of folks that are equity side people who meet like this, and clearly intrinsic value of company is a very big discussion with them, including things like normalized core earnings. So what we're trying to find out is whether or not their concerns and your concerns run parallel, or on different paths, and if so, how. [Also included in 5(a)] [TC 12/8, p. 13]
Participant C-1
We use multiples of cash flow. So we're using earnings before taxes, depreciation, amortization, and multiples of that. The problem with determining normalized or core earnings is the amount of so-called one time charges which are always run through a company's income statement. The amount of time spent looking at pro forma cash flows or pro forma earnings is tremendous. The number of companies selling divisions, selling plants, closing plants, or looking at buying companies and then merging them makes it very difficult for us to look at normalized cash flow and determining intrinsic value of that. [Also included in 1(c) and 5(a)] [TC 12/8, p. 13]
Participant C-7
Looking at it from a bank standpoint as a creditor, our focus is on quality of earnings, the composition of operating earnings, and whether that gives you a comfort level going forward that you're going to be repaid. Typically, we collateralize ourselves--we're in a senior position. So, intrinsic value of a company probably is a secondary or tertiary issue for us. [TC 12/8, p. 13]
Participant C-5
Actually from the bank group population, as well, I would contrast. We are a bank lender that maybe lends a little bit down the tier of bank credit. Bank debt or any debt is really just a put on equity for the owner of the company, and we have an understanding that that intrinsic value has a lot to do in determining our success, the customer's viability, and then ultimately the repayment of our debt as expected. We do play heavily into intrinsic values, both using price earnings multiples, and then also discounting methodologies. [Also included in 1(c)] [TC 12/8, p. 14]
Participant C-11
I maybe have a different approach because of the way we invest or whatever, but I think the way this is phrased is a little bit too skewed to the recent history of LBOs and divestitures and manipulations of that sort. In my mind, I'm hoping that I'm investing in something that has intrinsic value because that value is a going business, producing reasonably reliable amount of cash flow or profits which over time is going to allow me to get paid off. So, I think I'm thinking in a slightly broader framework than this is written in, because I don't think that you should really count all the time on getting bailed out by divestiture or sale at some multiple, because those things don't happen that easily. [TC 12/8, p. 14]
Committee/Staff/Observer
So would that drive you, [participant C-11], to quantify the intrinsic value? Or is it just a notional thing that says this company is good? [TC 12/8, p. 14]
Participant C-11
In my own work, I'm not thinking of a specific number or value. It's more that it has value because it produces whatever you have to have it produce, cash flow or earnings, or whatever it takes, and the ability to refinance and all those things that were mentioned earlier to allow me to be comfortable with holding the debt and knowing I'm going to get paid off. [TC 12/8, p. 14]
Participant C-14
We don't use intrinsic value. The people that are experienced and have seen that values are fleeting, generally find, I think, that intrinsic value for the creditor is not very useful. But a more important issue is the way this question is stated; it almost asks us to make a judgment about whether intrinsic value is something we should or shouldn't be using. And if [one company] likes to use intrinsic value, and [another] doesn't, I don't think that that really matters. Because when [participant C-5] does his work, or when I do my work, if he's doing intrinsic value and I'm doing cash coverage, we're both still using the same thing: core cash flow. So the real issue is what's the information that we need out of the accounting to answer [participant C-5]'s question, [participant C-11]'s question, or my question about. [TC 12/8, p. 15]
Participant C-4
We will use intrinsic value to try and determine whether or not it's prudent to allow goodwill in our analysis. For example, there has been a purchase and we are trying to determine what the value of that company is, we may use a weighted average intrinsic value calculation that used multiple of earnings, multiple of cash flows, and then about 10% or so, or a liquidation multiple. And we found that to be useful. The IRS also bought that calculation. So we felt that it was useful. [Also included in 1(c)] [TC 12/8, p. 15]
Participant C-1
Well, one of the interesting things about intrinsic value from a creditor's standpoint is that we operate as part of an overall financial community. We all have to be cognizant of the way the equity markets value companies because for all of us part of the way of improving a company's valuation is obviously to sell stock. I think that while a lot of us may not agree that PE multiples are a great way of looking at intrinsic value, they're very important in determining the company's ability to access the capital markets. And that intrinsic value is important because the equity market cares about it. [TC 12/8, p. 15]
Participant C-14
I think it's a really good point, because if there is high intrinsic value, the company can have more financial flexibility. But one of the problems that I think creditors face is what management intentions are. When equity values are high, management may be willing to sell some stock to bolster the balance sheet, but when equity values are low, for instance in [name deleted] case when they should have been selling stock when equity values were low, that they were instead buying stock, because [the Chairman's] view was that this stock was "undervalued." Management makes these judgments that really cloud the issue of how much that intrinsic value is going to help the creditor. [TC 12/8, p. 15-16]
Participant C-1
I agree with you, but management's intentions are unfortunately something that are never in financial statements. One of the key things that we look at is trying to determine management's intentions. Management's got the ultimate club, as far as creditor's are concerned, which is Chapter 11. And they use it more and more, and there's nothing we can do to control that. I agree [participant C-14] that the key thing for us is the ability to cover interest. However, if intrinsic value is not there, at any point in time management can exercise their ability to go into Chapter 11. Time after time, management comes out better after Chapter 11 than when they went in. [TC 12/8, p. 16]
Participant C-5
I think the whole issue of the equity markets does not change the intrinsic value of the company. What I've heard a few people mentioned is that the concept of value proved to be very ineffective in the eighties; I think it's because the information provided was not sufficient to make those valuation determinations. We were making some very subjective valuations. Because of the lack of information, we've always assumed price is value. [TC 12/8, p. 16]
Participant C-12
I think one of the reasons I'd come back to intrinsic value over time, without trying to put a value on a company, but just to determine that there is some value there, is that companies with value will attract capital. One other general thought; in looking at a financial institution, I look at two things. One is intrinsic value, the ability to generate earnings. The other is the impact of a discontinued operation, which is loan loss provisions. What I'm doing looking at a financial institutions is evaluating the ability to generate value from the core business against the cost of getting out of the business that went wrong. [TC 12/8, p. 16-17]
Participant C-3
We've increasingly gone to a concept of stressed capital where we look at the potential charge of a company's exit from a certain industry or geographic area and its impact on capital. [Also included in 1(c)] [TC 12/8, p. 17]
Participant C-14
I want to give an example of the problem we have with intrinsic value. [Name deleted] came in to get a rating and we all know [name deleted] had a high flying stock 18 months ago, $80 maybe. Its intrinsic value was tremendous, and if you rated it on intrinsic value you would have been well into an investment grade, maybe an A rating, and that's what the investment banking community was pushing. But if you did the analysis, the cash flow didn't support that kind of rating. And pure fundamental analysis told you that it wasn't good credit. And that's why we get scared about putting too much faith in intrinsic value. [TC 12/8, p. 17]
__________
Participant C-5
We've done some significant analysis in terms of moving to a re-rating system within our bank, modifying the past rating approach. What we've seen is a point where you shift your focus, whether it's accrual versus cash. On the high end credit accrual is very important because it really does get down to period reporting. Cash becomes important when liquidity and viability is more of a question. The same thing goes with things like segment reporting versus legal entity. The more concerned I am about viability, the further I move down the curve. If I am more concerned with the pieces of the debt, how I control the debt structure with the whole consolidated group, I then move up the curve. Businesses are not managing legal entities, they really are managing segments. The concept should be that we have a set of tools; obviously, as a bank creditor we can demand preparation of financial statements in certain fashions as long as we have an agreed-upon standard upon which those can be prepared. For a company that we would grade a borderline pass credit, we would not ask for segment reporting, we'd need legal entity consolidations. For a company that's a high grade multinational, typically they would provide more segment-type information. I don't believe standards should be different but the on- off switch should be there to shift the focus in the middle at the point where the debt holders make some determinations as to which are more important. I know that's a difficult thing to implement, but we have clearly seen that there is a shift about middle of the pass grade, which would be basically minimum investment grade type credit, there's a shift away from cash viability to accrual and legal entity to segment type information. [Also included in 3(b)] [TC 12/8, p. 22-23]
[Context] Responses to the postmeeting questionnaire to the December 8, 1992 Creditor Discussion Group meeting.
QUESTION 1
Do you agree with the following revised statement of objectives of financial analysis performed by creditors (including credit rating agencies, banks, and other institutional investors):
To assess the ability of a borrower or issuer of debt securities to meet obligations related to current or future debt or other financial instruments through timely payment of principal and interest or, as a last resort, through transfer of a collateralized asset.
That assessment involves considering some or all of the following pertaining to a borrower or issuer of debt securities:
•The long-term viability of a borrower to be able to operate as a going concern, including being able to access capital markets to meet future borrowing needs,
•The appropriateness of and borrower's ability to meet lending agreement covenants,
•The fair or market values of its assets pledged as collateral on its debt,
•Management's objectives, particularly in relation to a borrower's current and proposed borrowings,
•The fair or market values of its assets pledged as collateral on its debt, and
•In some circumstances, the ability of the company's debt to be traded in secondary markets.
•Other :
Participant C-3 - Fair or market values of assets not pledged as collateral.
Participant C-14 - Ability to liquidate collateral in a timely fashion without undue impairment of its protection of debt service.
Participant C-10 - The projected cash flow of the borrower and how it relates to the interest payments, debt amortization, and capital expenditures.
Do you generally accept this revised statement of objectives?
_ YES _ NO
14 2
If NO, what changes would you make?
Participant C-10 - Use the term "cash flow". Don't be afraid to use such a common term. Try #7 and number it #1 - it covers some of point #1 but is much more inclusive.
Participant C-18 - I agree with everything except references to assessing fair value of assets pledged as collateral. Financial statements, GAAP or otherwise, are not reliable sources of information for such purposes; they can significantly overstate or understate value as "value" relates to collateral for a debt obligation.
Participant C-9 - The appropriate risk premium level to "risk free" treasuries in the secondary market to balance the fundamental credit risk with reward.
[PMQC 12/8, p. 1-2]
__________
QUESTION 3
a. If you estimate the "intrinsic value" of the borrower's business, that is, the value of the business as a whole, do you agree with the following (leave blank if you do NOT make this estimation)?
The principal purposes of estimating the value of a borrower's business include:
Participant C-3 - Ability of the borrower to raise capital through asset sales.
Participant C-14 - Do not use.
Participant C-15 - Do not compute. Cash flow is the basis of an analysis.
Participant C-10 - Assisting in determination of potential sale. Value Co. (chapter 7 for liquidation or more likely going concern values used in a Chapter 11 case)
Participant C-12 - I can be wrong, i.e., in evaluating various aspects of a company's business (both because of my error in judgment and the company's shortcomings in presentation). Uncertainty about specific judgments, e.g., ability to replace a maturity bank loan, is more or less important based on the greater or lesser intrinsic value of the company. (This may simply be a broader way of stating points "i" and "ii", which are examples of uncertainties that will affect future performance.)
Participant C-4 - To determine the ability of the borrower to handle additional equipment debt, increased backlog or revenues or handle changes in the nature of the operation.
Participant C-18 - N/A
Participant C-16 - Regarding 3ai: Such ability to weather adversity may include access to capital (ability to borrow). Other Reason: Compare book value to market.
Participant C-2 - I generally only make this estimation in loans for the purpose of acquiring an existing business. I compare the contract price with intrinsic value, to ensure that my customer is not overpaying for the business. I will also use asset appraisals to help make that determination, along with DCF methods.
Participant C-19 - Other Reason: Plus possibly some amount for the market value of the company's real estate over its book value.
[PMQC 12/8, p. 7-8]
[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of value information. During the discussion, comments were made on creditors' objectives and approaches.
Participant C-7
From a banking standpoint, our focus is on that which we've taken for collateral, generally fairly specific tangible assets as opposed to trying to value the intrinsic value of a business. We really don't get concerned with value until we are in liquidation. [Also included in 4] [TC 2/2, p. 2]
Committee/Staff/Observer
Are you saying that ability to recover amounts otherwise uncollectible are where you're coming from? [Also included in 4] [TC 2/2, p. 2]
Participant C-7
Yes. [Also included in 4] [TC 2/2, p. 2]
__________
Participant C-17
I get real interested in what assets are worth or what the fair market value is the more I rely on security or also as a way to try to evaluate an extra strategy if the company fails. But in the normal course of business, I'm going to be looking to the ability of the company to pay, I don't want to liquidate the company in order to get repaid. I'm looking at that more as a backstop. I look also at market value to make the decision as to whether or not and what type of collateral I need. [Also included in 4] [TC 2/2, p. 4]
[Context] The paper is a summary of a committee and staff members' discussions with selected sell-side analysts from Bear Stearns:
"Morning Call" is a meeting (usually via a conference call) between the Bear, Stearns analysts and the sales force where the analysts communicate the results of recent research (and a strong, buy, hold, or sell recommendation) and the expected impact on securities of recent information (e.g., press releases, meetings with analysts, changes in interest rates, economic outlook, and other market factors). [Also included in 1(b)] [BEAR STEARNS, p. 1]
Items mentioned during the analyst reports on the morning call were as follows . . . :
* Oil reserve increases resulting from recent drilling activities
* Sales trends, profit margin trends, sales by product line
* Gross margin trends
* Impact on tax rate resulting from nondeductible goodwill
* Foreign currency benefits
* Core business trends and focus markets
* Earnings momentum
* Leading indicators for a particular company and/or industry.
[Also included in 1(b)] [BEAR STEARNS, p. 1]
[One analyst] expressed the following . . . regarding his approach to securities analysis: [Also included in 1(b), 2(c), and 15] [BEAR STEARNS, p. 1]
* His model is earnings (P& L) oriented and focuses on gross margin trends and the momentum of earnings. [BEAR STEARNS, p. 2]
[One analyst] stated that his analysis of a security does not use a discounted cash flow approach, except on certain "asset plays" (i.e., companies that have assets that Wall Street has overlooked-- "hidden assets"). [BEAR STEARNS, p. 2]
[One analyst commented on the] following regarding her approach to securities analysis and financial reporting in general: [Also included in 1(b), 5(c), 6, and 15] [BEAR STEARNS, p. 3]
* Her securities analysis model uses a variation of a "free cash flow" approach. [BEAR STEARNS, p. 3]
[Context] Annually, the Corporate Information Committee [CIC] of the Investment Management and Research rates the annual reports of publicly held companies. The checklist presented below contains the questions the CIC analysts consider in performing their evaluations.
CHECKLIST OF CRITERIA FOR EVALUATING FINANCIAL COMMUNICATIONS EFFORT
Qualification Questions (mandatory for each subcommittee's evaluation form)
1. To your knowledge, during the past year has the management of this company suppressed or misrepresented material facts adverse to the company and/or its operations or outlook?
2. In your opinion, are any accounting or other managerial practices of this company materially misleading?
3. In your opinion, is this company unduly dilatory with respect to its press releases and/or earnings statements?
(If you have answered any of these questions in the affirmative, do not proceed with the rating of this company but contact the subcommittee chairman. An affirmative answer to one of the questions by two or more subcommittee members will disqualify the company from being considered in this year's rating.)
Note: The percentage weights appearing after each major category title (below) can be distributed to subcategories in whatever manner seems appropriate to each subcommittee. [AIMR/CIC92, p. 109]
I. Annual Published Information (40% to 50% of total weight)
A. Annual Report
1. Financial Highlights--(is it clear and unambiguous?)
2. President's Letter Review--(Does it hit the highlights of the year in an objective manner? Is it relevant to the company's results and candid in appraising problems?)
It should include:
a. Review of the year.
b. Insights into operating rates, unit production levels and selling prices.
c. Acquisitions and divestments, if any.
d. Government business, if material.
e. Capital expenditures program; start-up expenses.
f. Research and development efforts.
g. Employment costs, labor relations, union contracts.
h. Energy cost and availability.
i. Environmental and OSHA costs.
j. Backlogs.
k. New products.
l. Legislative and regulatory developments.
m. Outlook.
n. Unusual income or expense. [AIMR/CIC92, p. 109]
3. Officers and Directors
a. Age, background, responsibilities of officers.
b. Description of company organization.
c. Outside affiliations of directors.
d. Principal personnel changes. [AIMR/CIC92, p. 109]
4. Statement of Corporate Goals
What are the short- and long-term corporate goals and how and when does management expect to achieve them? (This section could be included in several areas of the report but separate treatment is preferred.) [AIMR/CIC92, p. 109]
5. Discussions of Divisional and/or Segment Operations
a. How complete is the breakdown of sales, materials, costs, overhead, and earnings?
b. Are the segments logical for analytical purposes? Do they parallel lines of business?
c. Are unusual developments explained with management's response included?
d. Note comparisons with relevant industry developments to include:
1. Market size and growth.
2. Market penetration.
3. Geographical divergencies.
e. Foreign operations:
1. Revenues, including export sales.
2. Consolidated foreign earnings vs. equity interest.
3. Market and/or regional trends.
4. Tax status. [AIMR/CIC92, p. 109]
6. Financial Summary and Footnotes
a. Statement of accounting principles, including explanation of changes and their effects.
b. Adjustments to EPS for dilution.
c. Affiliates-operating information.
d. Consolidated finance subsidiaries-disclosure of separate balance sheet information and operating results.
e. Cash flows statement (FAS 95).
f. Tax accounting-investment tax credits identified; breakdown of current and deferred for US and non US tax jurisdictions; reconciliation of effective and statutory tax rates; impact of changes in tax law; early application of FAS 96.
g. Clarity of explanation of currency exchange rate accounting.
1. Impact on earnings from Balance Sheet translation if any.
2. Indication of "Operating" or Income Statement Effect of exchange rate fluctuations.
h. Property accounts and depreciation policies:
1. Methods and asset lives used for tax and for financial reporting.
2. Quantification of effect on reported earnings of use of different method and/or asset lives for tax purposes.
i. Investments: composition and market values disclosed.
j. Inventories: method of valuation and identifying different methods for various product or geographic segments.
k. Leases, rentals: terms and liability.
l. Debt repayment schedules.
m. Pension funds: costs charged to income, interest rate and wage inflation assumptions; amount of any unfunded past service liability; amortization period for unfunded liability (FAS 87).
n. Other postemployment benefits: pay-as-you-go amount, discussion of potential liability and impact of FASB Standard 106, including plans to fund, or amend plans, and Standard 112.
o. Capital expenditure programs and forecasts, including costs for environmental purposes.
p. Acquisitions and divestitures (if material):
1. Description of activity and operating results.
2. Type of financial transaction.
3. Effect on reported sales and earnings.
4. Quantification of purchase acquisitions or small poolings that do not require restatement of prior years' results. (When restating for pooling, both old and new data are useful for comparison.)
q. Year-end adjustments.
r. Restatement of quarterly reports to year-end accounting basis.
s. Research and development and new products; amount and types of outlays and forecasts.
t. Contingent liabilities, particularly environment.
u. Derivation of number of shares used for calculating primary and fully-diluted earnings per share.
v. Disclosures of the fair values of financial instruments (FAS 107).
w. Goodwill-amount being amortized and number of years.
x. Ten-year statistical summary:
1. Adequacy of income statement and balance sheet detail.
2. Helpfulness of "nonstatement" data (e.g. number of employees, adjusted number of shares, price of stock, capital expenditures, etc.) [AIMR/CIC92, p. 110]
B. 10-Ks, 10-Qs and Other Required Published Informatio