1(c). Investors' and Creditors' Use of Information to Achieve Their Objectives
Review of the Summary of Robert Morris Observations on the Uses of Financial Information: All banker participants felt as if [the] one page summary was a fair representation of our views on the matters discussed [at the March 11, 1992 meeting with the AICPA Special Committee. The summary follows: [RMA92, p. 13]
Financial statements are the beginning point for answering "How will the Company repay us?"
Financial statements would be easier to use in computer readable diskette format because its makes analysts' rearrangement of information easier to apply.
Direct Method formats of cash flows are more useful than indirect method. Most bankers convert indirect to direct data as best as they can.
Information disaggregated by product/line of business is needed to analyze payback ability.
One year cash budgets are frequently requested by lenders to gain understanding they believe would have been derivable from historical (cash flow) statements if such statements had been disaggregated by product line or other division. Financial statements would be more useful to bankers if the statements presented disaggregated cash flow information on a historical basis and also, perhaps include a one year cash flow forecast.
Market value information on assets has low interest because operating cash flows are considered the primary source of repayment, not the asset. Asset values are looked at from orderly liquidation of business viewpoint and then only to assess risk if the primary source fails. Historical cost regarding long-lived assets is used to evaluate equipment age and need for reinvestment capital.
Historical cost is not considered to need replacement by fair value. In particular, discounted cash flow is seen as too dependent on subjective judgements to provide the three to five year comparability and consistency needed for credit analysis. Other valuation methods are also observed to be too subjective in comparison to historical cost. Moreover the focus on cash flow makes "value of assets" a secondary concern of risk assessment.
Disclosure of claims on cash is important in a wide range of disclosures from current liability classification to FAS 87 pension disclosures.
RMA believes financial statements should reflect the borrowers' judgement within the framework of consistently applied generally accepted accounting principles. Non-GAAP presentations introduce other types of "judgement" differences in financial data that are difficult to "filter" and analyze.
Along with disaggregated information, better ways to highlight unusual or infrequent items would help credit analysts.] [RMA 92, p. 1]
__________
FAS 106 requires employers to account for their retiree welfare benefit liabilities on an accrual, rather than "pay-as-you-go" basis. Although accrual accounting doesn't "create" costs, it does require companies to recognize and disclose future benefit payments in their current financial statements. And for a typical company, annual FAS 106 costs will be about six times greater than pay-as-you-go costs. [TOWERS PERRIN, p. 1]
Nevertheless, some observers have argued that investment professionals will generally ignore FAS 106 because the new accrual accounting standard has no effect on a company's current cash flows. Most of the survey respondents, however, take a different view. Just under two-thirds (63%) believe that FAS 106 liabilities represent a significant future cash cost that should be reflected in current equity valuations. [Also included in 1(b)] [TOWERS PERRIN, p. 2]
The survey participants . . . disagree with the notion that FAS 106 will have a "uniform" impact on all companies and, thus, can be generally discounted. Fully 71% of the group believe that comparable companies will show substantially different FAS 106 costs. [TOWERS PERRIN, p. 2]
A Towers Perrin analysis of 1991 retiree welfare valuation data supports this view. In this analysis, annual FAS 106 costs for a 147-company sample range from $428 to $9,230 per active employee. Similarly, in a Towers Perrin survey conducted earlier this year, a group of 150 employers reported FAS 106 reductions in pretax earnings ranging from less than 5% to 30% or more. The average earnings reduction for this group was 17%. [Footnote references omitted.] [TOWERS PERRIN, p. 2]
While some observers argue that the financial community has fully anticipated the effects of FAS 106, the survey respondents generally agree that a complete reckoning won't come until after the adoption deadline. (Most companies must adopt the standard by the first quarter of 1993.) Moreover, just over half of the survey respondents (51%) say that "surprises" will be common-because market expectations are based on incomplete information and do not anticipate variations in individual company results. [TOWERS PERRIN, p. 2]
Experience with companies that have adopted FAS 106 in advance of the deadline corroborates that view. In 1991, for example, both IBM and GE announced onetime FAS 106 charges in excess of $2 billion. Although significant, these figures were lower than expected-largely as a result of factors that are not normally disclosed in public documents or are up to management discretion. [TOWERS PERRIN, p. 2]
More than two-thirds (69%) of the survey group say that a company's stock price would decline if reported FAS 106 expense were higher than expected. Although many of the respondents are reserving judgment about specific price effects until they have full information on FAS 106 costs, more than half (55%) did offer predictions. [TOWERS PERRIN, p. 3]
These investments professionals say, on average, that a company's stock price would drop 6% if its reported reduction in the earnings were 10% greater than expected. Their predictions for price reductions in this hypothetical case range from 1% to 20%. More than a third (35%) anticipate price declines of 10% or more. [TOWERS PERRIN, p. 3]
Not surprisingly, more equity experts are concerned about the impact on earnings than the effect on net worth. Just over half (51%) said a company's stock price would drop if its reported FAS 106 liability, as a percentage of net worth, were 10% higher than anticipated. Interestingly, however, the money managers-who purchase equities on behalf of major institutions (including pension funds)-are more sensitive to net worth: 56% of this group say stock prices would be affected by unexpectedly large reductions in net worth, while only 46% of the broker group say prices would be affected. [TOWERS PERRIN, p. 3]
According to the survey, the decision employers make about how-and when-to adopt the new accounting standard will not go unnoticed in the investment community. In general, the survey respondents tend to favor conservative FAS 106 expensing strategies. . . .For example, about half (51%) say the markets will view early adoption favorably. Clearly, early adoption gets the problem out of the way-and gives the investment professionals the information they want about a company's liabilities and expense. [Also included in 1(b)] [TOWERS PERRIN, p. 3]
Similarly, many of the survey respondents (47%) express a positive view of companies that take the transition obligation for past employee service as a onetime "hit," rather than amortizing it. This finding supports the view that investors might be inclined to discount a large onetime charge, particularly because this approach reduces future expense. (For a typical company, taking the hit up front would reduce future annual expense by about 30% and allow the company to show earnings from continuing operations that are more than 10% higher.) [Also included in 1(b)] [TOWERS PERRIN, p. 3-4]
Notably, over half (56%) of the survey respondents say "conservative" (i.e., higher than average) medical trend assumptions will be viewed positively. This finding suggests that, although conservative assumptions will tend to depress earnings initially, investment professionals would rather see a company report the "worse case" at the outset-so that future expense revisions, if any, would take a downward rather than upward direction. [Also included in 1(b)] [TOWERS PERRIN, p. 4]
Interestingly, the money managers in the survey group express slightly stronger opinions about expensing strategy. Well over half (59%) say they view early adoption favorably, while only 42% of the broker group shared that opinion. The money managers are also more positive about conservative medical trend assumptions: 64% express a favorable view of higher-than-average assumptions, while 52% of the broker group take that view. (The two groups offer similar opinions about companies that take the transition charge up front.) [Also included in 1(b)] [TOWERS PERRIN, p. 4]
While the equity experts are clearly concerned about bottom line numbers, the [FAS 106] survey results show that the actions employers take to control future costs-i.e., benefit design and funding strategies-will also have an impact on the investment community's assessment of a company's financial position. [Also included in 1(b)] [TOWERS PERRIN, p. 4]
Specifically, the survey group strongly favors caps on future expenditures-such as a "defined dollar benefit" designed to protect the company against the effects of inflation. Fully 81% say caps would have a positive impact on the way the markets view a company's financial position. Most of the survey respondents (65%) also view funding positively, despite the fact that this strategy reduces corporate cash available for investment (or for shareholders in the event of bankruptcy). [TOWERS PERRIN, p. 4]
It's worth noting that, in the Towers Perrin employer survey, 18% of respondents had imposed caps on company contributions for future retirees and 7% had taken that approach for current retirees. An additional 29% were planning or considering caps for future retirees. Very few (under 10%) were funding their benefit liabilities at the time. Employer efforts to redefine benefit design and funding strategies have, however, increased in recent months and are likely to continue as more companies confront their FAS 106 costs. [TOWERS PERRIN, p. 4-5]
Most equity experts recognize that full information on FAS 106 costs won't be available until all companies adopt the new standard during the first quarter of 1993. In the meantime, however, more than three-quarters of the survey respondents (77%) say their firms' equity valuation analyses include an examination of a company's footnoted retiree welfare disclosures. (These disclosures are required by the SEC for annual reports and other financial statements.) [Also included in 1(b)] [TOWERS PERRIN, p. 5]
Moreover, many of the survey respondents (62%) currently factor in some estimate of FAS 106 costs when preparing equity valuations, earnings forecast, buy/sell/hold recommendations and other analyses for clients. Among those who do factor in FAS 106 costs, more than half (57%) include some sort of explicit analysis. [TOWERS PERRIN, p. 5]
For example, about a third (34%) of those who factor in retiree welfare costs note FAS 106 expense estimates in their equity research reports. More than a quarter (27%) make explicit distinctions between companies that recognize the past service obligation and those that amortize it. Just under 20% say they make specific reference to FAS 106 costs in other ways (such as a before/after analysis). Some of the respondents use more than one of these approaches. [TOWERS PERRIN, p. 5]
Only about a quarter of the survey respondents (26%) say they use benchmarks in their efforts to estimate the impact of FAS 106. Of those who do use benchmarks, just under half (49%) say they develop liability and/or expense estimates based on a benchmark multiple of current pay-as-you-go costs. Fewer use benchmark reductions in pretax earnings or net worth (28% and 32%, respectively). [Also included in 1(b)] [TOWERS PERRIN, p. 6]
[Regarding adoption of FAS 106] in preparing analyses for a specific company, many of the survey respondents (58%) make adjustments for certain company-specific factors. Most of these equity experts say they look at employee demographics (71%), whether the workforce is unionized (62%) and the nature of the benefit plan (52%). . . .Notably, the brokers in the group look more closely at employee demographics and the benefit plan than the money managers do. Fully 80% of the brokers cite employee demographics as a factor, while 57% of the money managers do; 61% of the brokers say they look at the nature of the benefit plan, while 38% of the money managers cite the plan as a factor. [Also included in 1(b) and 13] [TOWERS PERRIN, p. 6]
The diverse opinions expressed by the survey group on some issues are understandable for a number of reasons-not the least of which is the FAS 106 information gap. Retiree welfare costs are largely determined by factors that are not normally disclosed to the public. And relatively few employers began to report their FAS 106 data until this year-in 1991 annual reports, for example. [Also included in 16(b)] [TOWERS PERRIN, p. 7]
Moreover, those data are preliminary in most cases. One reason is the fact that management discretion-in developing expensing, benefit and funding strategies-plays a critical role in determining the magnitude of FAS 106 expense. So although FAS 106 is an "objective" standard, it's difficult to anticipate how much of a difference changing conditions would make between preliminary and final results for individual companies. It's also unlikely that any two companies will take exactly the same approach to managing costs. [Also included in 16(b)] [TOWERS PERRIN, p. 7]
Given these factors, it's not surprising that 69% of the survey group say that management efforts to communicate with the investment community about FAS 106 issues will have a positive impact on assessments of a company's financial position. . . .Employers might therefore want to include investor communications in their FAS 106 adoption plans. [Also included in 16(b)] [TOWERS PERRIN, p. 7]
Another factor is that FAS 106 is uncharted territory for most equity experts. Treatment of nonrecurring "events" (such as dividend cuts, earnings reductions) and other past experiences (such as FAS 87), although similar in some ways, haven't fully prepared investment professionals for the complexity they face in evaluating retiree welfare benefits costs. [Also included in 16(b)] [TOWERS PERRIN, p. 7]
Whether FAS 106 will have an impact on corporate credit ratings and borrowing capacity remains to be seen. Credit ratings are based primarily on cash flow and financial flexibility. And since neither will be directly affected by FAS 106, the rating agencies are generally inclined to view the new accounting standard as a "nonevent"-at least as far as specific ratings go. [Also included in 1(b)] [TOWERS PERRIN, p. 8]
In a report released last year, for example, Standard & Poor's (S&P) said that FAS 106 "is not expected to have any widespread impact on debt ratings, since cash flow will not be affected directly." Moody's has also stated that "rating changes are not anticipated" as a result of FAS 106, because "this liability has been factored into our ratings." Moreover, some credit analysts believe that FAS 106 may have positive credit implications for some companies, because it encourages them to limit generous retiree medical benefit plans. [Footnote references omitted.] [Also included in 1(b)] [TOWERS PERRIN, p. 8]
Nevertheless, the rating agencies indicate that they will look more closely at retiree welfare liabilities as a result of FAS 106. Moody's says that FAS 106 "will clearly impact the reported financial statements of some companies more than others," and that it "will review carefully the assumptions underlying the numbers." Similarly, S&P says that retiree welfare obligations "represent a substantial and growing burden for many companies" and will therefore subject those liabilities to greater scrutiny. [Also included in 1(b)] [TOWERS PERRIN, p. 8]
Other market observers believe that companies considered "marginal credits" will feel the effects of FAS 106 more than others. Even without a rating downgrade, "increases in reported retiree medical expenses and the disclosure of the cumulative liability may impair market access and cause new issue borrowing spreads to widen" for these companies. These analysts also expect that some companies may violate net worth or leverage covenants in existing debt agreements as a result of FAS 106. But because issuers are likely to factor FAS 106 into future covenant negotiations, future borrowings may not be affected. [Footnote references omitted.] [Also included in 1(b)] [TOWERS PERRIN, p. 8]
Clearly, employers shouldn't expect institutional analysts and investors to overlook the effects of FAS 106. The Towers Perrin survey shows that, despite the temporary information gap, many investment professionals are paying close attention to retiree welfare liabilities and how companies manage them. In fact, a significant percentage of the survey respondents (47%) say that a company's ability to manage retiree benefit costs is a strong indicator of overall management effectiveness. [Also included in 1(c)] [TOWERS PERRIN, p. 8]
Especially critical are the specific strategies companies develop for managing expense and controlling future costs. While the survey demonstrates that earnings from continuing operations is still the most closely watched indicator of corporate performance, equity experts are also influenced by qualitative factors-including management's approach to valuation assumptions, timing, benefit design and funding. [Also included in 1(b)] [TOWERS PERRIN, p. 8]
The survey results clearly indicate that employers should consider investor expectations when they're making FAS 106 decisions. Expensing strategy is a good example. Following is a closer look at the issues. [Also included in 1(b)] [TOWERS PERRIN, p. 8]
Assumptions. FAS 106 allows employers to develop "best estimates" for key expense variables such as interest rates, expected retirement ages and health care cost "trend" (the rate of increase in per capita health care prices and usage). Assumption decisions can, in turn, have a significant impact on the charge against earnings. For example, if a typical manufacturing company lowered its long-term health care trend assumption by 2%, FAS 106 expense would drop by as much as 30%. [Also included in 1(b)] [TOWERS PERRIN, p. 9]
What's the best approach? The investment community won't look favorably on an unexpectedly large expense-either initially, or later if upward revisions become necessary. Many equity experts probably favor conservative assumptions for that reason. On the other hand, minimizing expense is clearly important. [Also included in 1(b)] [TOWERS PERRIN, p. 9]
So the key is to strike a reasonable balance-i.e., an approach that avoids overstating or understating expense. In any case, a company's FAS 106 assumptions, whether conservative or aggressive, should be consistent with management's general approach to financial reporting. [Also included in 1(b)] [TOWERS PERRIN, p. 9]
Taking the transition 'hit.' As the survey results show, most investment professionals are more concerned about earnings reductions than reductions in net worth, and many would be inclined to discount large onetime charges. And since charging the transition obligation up front substantially reduces the FAS 106 impact on future earnings, most companies will take that approach if they can afford it-i.e., if net worth is sufficient to absorb the onetime charge. (Those whose initial liability amounts to less than 50% of net worth will generally choose to take the charge.) [Also included in 1(b)] [TOWERS PERRIN, p. 9]
__________
While 55 percent of the individual sample find annual reports useful to investment decisions, individuals gave annual reports a low rating as a source of information on buying and selling stock -- ranking them next to last among seven information sources. [Also included in 1(b)] [HILL KNOWLTON, p. 7]
INDIVIDUAL INVESTOR[S'] VIEWS ON THE USEFULNESS OF VARIOUS TYPES OF INFORMATION]
For [the statement below], would you say that you agree or disagree with it?
Annual reports are useful to me in making investment decisions.
Results in percentages
TOTAL
AGREE 54.7
DISAGREE 34.4
DON'T KNOW/NO 10.9
ANSWER
TOTAL 100.0
[HILL KNOWLTON, TABLE 13]
Using a 0-to-10 scale, with 0 being a not at all important source and 10 being a very important source, please indicate how you would rate [Stockbrokers' recommendations] for providing information on buying or selling a stock.
Results in percentages
TOTAL
A NOT AT ALL
IMPORTANT SOURCE 27.9
SOMEWHAT IMPORTANT 24.7
A VERY IMPORTANT
SOURCE 45.3
DON'T KNOW/NO 2.0
ANSWER
TOTAL 99.9
[HILL KNOWLTON, TABLE 14]
Using a 0-to-10 scale, with 0 being a not at all important source and 10 being a very important source, please indicate how you would rate [Friends'/relatives' recommendations] for providing information on buying or selling a stock.
Results in percentages
TOTAL
A NOT AT ALL
IMPORTANT SOURCE 48.2
SOMEWHAT IMPORTANT 34.0
A VERY IMPORTANT
SOURCE 15.4
DON'T KNOW/NO 2.4
ANSWER
TOTAL 100.0
[HILL KNOWLTON, TABLE 15]
Using a 0-to-10 scale, with 0 being a not at all important source and 10 being a very important source, please indicate how you would rate [Articles in the press] for providing information on buying or selling a stock.
Results in percentages
TOTAL
A NOT AT ALL
IMPORTANT SOURCE 17.8
SOMEWHAT IMPORTANT 38.1
A VERY IMPORTANT
SOURCE 41.3
DON'T KNOW/NO ANSWER 2.8
TOTAL 100.0
[HILL KNOWLTON, TABLE 16]
Using a 0-to-10 scale, with 0 being a not at all important source and 10 being a very important source, please indicate how you would rate [Annual reports] each source for providing information on buying or selling a stock.
Results in percentages
TOTAL
A NOT AT ALL
IMPORTANT SOURCE 29.1
SOMEWHAT IMPORTANT 40.9
A VERY IMPORTANT
SOURCE 25.1
DON'T KNOW/NO ANSWER 4.9
TOTAL 100.0
[HILL KNOWLTON, TABLE 17]
Using a 0-to-10 scale, with 0 being a not at all important source and 10 being a very important source, please indicate how you would rate [Business programs on radio and television] for providing information on buying or selling a stock.
Results in percentages
TOTAL
A NOT AT ALL
IMPORTANT SOURCE 22.7
SOMEWHAT IMPORTANT 38.5
A VERY IMPORTANT
SOURCE 34.8
DON'T KNOW/NO ANSWER 4.0
TOTAL 100.0
[HILL KNOWLTON, TABLE 18]
Using a 0-to-10 scale, with 0 being a not at all important source and 10 being a very important source, please indicate how you would rate [Statistical services, such as S&P and Value Line] for providing information on buying or selling a stock.
Results in percentages
TOTAL
A NOT AT ALL
IMPORTANT SOURCE 11.7
SOMEWHAT IMPORTANT 20.6
A VERY IMPORTANT
SOURCE 62.3
DON'T KNOW/NO ANSWER 5.3
TOTAL 99.9
[HILL KNOWLTON, TABLE 19]
Using a 0-to-10 scale, with 0 being a not at all important source and 10 being a very important source, please indicate how you would rate [Your own analysis of stocks as an investment] for providing information on buying or selling a stock.
Results in percentages
TOTAL
A NOT AT ALL
IMPORTANT SOURCE 8.1
SOMEWHAT IMPORTANT 14.6
A VERY IMPORTANT
SOURCE 72.1
DON'T KNOW/NO 5.3
ANSWER
100.1
[HILL KNOWLTON, TABLE 20]
__________
Virtually all investors want unbiased, candid, unembellished investment information. They do not want sales pitches from brokers, optimistic expectations (or self-serving excuses) from company management, or information distorted by inappropriate interpretation and analysis. Most investors, especially the professionals and the semiprofessional individual investors, think that they can spot biases; some believe that they can filter out the biases to reach some degree of objectivity. If they cannot eliminate the biases for themselves, they place high value on information sources that can do so, either analytically or based on experienced judgment. [Also included in 1(a)] [SRI, p. 34-35]
Not only is the annual report one of the most readily available of sources, and certainly a low-cost source to users, but it has the most nearly comprehensive coverage of the types of information most needed by investors. Yet, the annual report has no role in the securities purchase decisions of most individual investors, and only a limited role in the decision to sell securities. It serves primarily as a reference document and, for many, a source of reassurance about their investments. Individual investors rarely even see the annual report until after they own a company's securities. The report is somewhat more important for the semiprofessional individual investors, whose analytical decision-making styles draw from data and financial information found in the annual. [Also included in 1(b)] [SRI, p. 51]
Professional investors are influenced to a greater degree by the annual report, although it still ranks only fifth in its importance to them. As with the individuals, the annual report is the most used source but not the most useful source. Virtually all professionals state that they always obtain both the annual report and SEC Form 10K prior to making investment decisions. Professionals complain, however, that companies often provide professionals with annual reports, but not with 10Ks--a careless omission in their view. [Also included in 1(b)] [SRI, p. 51]
Professionals discard about one-third of the annual reports they receive. Those they keep they use as reference sources for analysis and report writing. On average, each professional receives 324 annual reports per year, with sell-side analysts receiving 439, the buy-side professionals 343, and the brokers 187. [Also included in 1(b)] [SRI, p. 51]
Very few investors read the entire annual report when they receive it, although professionals eventually read all the annual reports on companies they follow. Reading patterns are highly selective, either focused and directed in the case of sophisticated investors who know the information they want and who specifically seek it out in the annual, or less focused for those who go through the report more casually, reading in depth those items that attract their interest. When asked what they do with annual reports when they arrive, investors provided the responses shown [below]. [Also included in 1(b)] [SRI, p. 52]
Reading the Annual Report
Professional
Action Investors
Individual
Throw it away 3.9% Investors (not asked)
without reading
it
File it or save 3.0 9.4%
it without
reading it
Skim the whole
report to get a
general
impression of 27.0 21.7
the company
Glance through
it, stopping to
read
what attracts 34.5 29.8
attention
Seek out specific 22.7 33.4
items of
information
Read the entire 8.6 5.0
report
Note: Findings are based on responses to the question, "Which of the following statements most nearly describes the way you read an annual report when you first receive it?"
Source: SRI International survey, 1986. [Also included in 1(b)] [SRI, p. 52]
"Reading," to most individuals, seems to include casually looking over the material and drawing some meaning, however, small, from it. To the professionals, reading means going through all the material and paying close attention to it. What the professionals call reading, the individuals might call studying. [Also included in 1(b)] [SRI, p. 52-53]
Professionals read annual reports in two different ways and at different times. When they first receive annual reports they glance through them, reading a few items of interest; then they either discard the reports or keep them for future reference. Later, the annual reports that were retained are read and analyzed in considerable detail. [Also included in 1(b)] [SRI, p. 53]
Individual investors are not nearly as aware of the various parts of the annual report as are the professionals. Individuals tend to think in terms of the front and the back of the annual. The front, consisting of the narrative part of the report, is generally understandable, although not always useful or interesting. The back, consisting of "the numbers," is generally considered important, but not very comprehensible. While not always familiar with specific parts of the annual, individuals have formed opinions on their importance for decision making. The professionals, on the other hand, discriminate easily among the various parts of the annual and find them all understandable. [Also included in 1(b)] [SRI, p. 53]
[The] table [below] shows the importance of various parts of the annual report to both individuals and professionals. Being selective in their reading patterns, professionals focus on those parts of the annual report providing the most relevant information. In virtually all instances, the professionals read the financial statements and the footnotes, while paying varying amounts of attention to the other sections. [Also included in 1(b)] [SRI, p. 53]
Individuals often recognize the importance of sections they might not fully understand and value what little meaning they can extract from those sections. For that reason, even the many individuals who profess not to understand much of the income statement, for instance, place high importance on that statement. Furthermore, they seek interpretation about the company's earnings stream from the other information sources they use and from advisors whose competence they trust. [Also included in 1(b)] [SRI, p. 53]
Somewhat surprisingly, individual investors rate the financial statements as more important than the narrative, less quantitative parts of the [annual] report, for several reasons. Primarily, of course, is the fact that financial performance is most clearly stated in numerical terms--a few simple terms for unsophisticated investors, plus numerous complex and abstract terms for sophisticated investors. For all their variation and occasional inaccuracy, numbers convey an impression of precision and clarity. The narrative parts of the annual report convey less precision, give more latitude for interpretation by the reader, and allow more room for manipulation by the writer. Importantly, the numbers in the annual report are known to be more closely reviewed by outsiders, specifically, the CPA firm conducting the audit and presenting its findings in the auditor's opinion included in each annual report. In addition, the SEC requires annual reports and other corporate communications to meet certain standards of disclosure. Finally, virtually all investors understand that financial statements are governed, however imperfectly, by accounting principles and conventions. None of these disciplines is believed to be infallible, but few comparable disciplines are applied to the narrative parts of the annual report; hence, the narrative portions are felt to be less reliable sources of information. [Also included in 1(b) and 13] [SRI, p. 53&55]
Importance of Annual Report Sections
Individual Professional
Investors Investors
Percent of Percent of
Users Rating Users Rating
Percent Important or Important or
Who Read Extremely Extremely
This Section Important Rank Important Rank
Income 84.9% 78.6% 1 94.2% 1
statement
Balance sheet 82.1 75.0 2 90.1 2
Footnotes to 51.4 42.9 8 80.4 3
financial
statements
Sources and 74.6 72.7 3 76.3 4
uses of
funds
Historical 70.3 46.2 7 69.6 5
operating
results
Quarterly 65.5 39.7 9 68.3 6
reports
Financial 82.3 57.2 4 65.7 7
highlights
Divisional or 56.6 55.3 5 63.1 8
business
segment
reviews
Management's 76.1 51.1 6 56.7 9
review
Chairman's/pre 77.8 31.4 12 45.8 10
sident's
letter
General 63.5 33.3 11 44.9 11
company and
product
information
Auditor's/CPA' 55.6 34.9 10 39.4 12
s
opinion
List of 59.4 19.8 13 19.2 13
officers and
directors
Source: SRI International survey, 1986. [Also included in 1(b)] [SRI, p. 54]
In their use of annual reports, semiprofessional individual investors behave more nearly like the professionals than like the other investors. They generally score all parts of the annual higher, and their importance ratings reflect a pattern similar to that of the professional analysts. [Also included in 1(b)] [SRI, p. 55]
The four lowest ranked parts of the annual report are the same for both professionals and individuals. These are the chairman's/president's letter, general company and product information, the auditor's/CPA's opinion, and the officer and director information. [Also included in 1(b), 13, and 17(f)] [SRI, p. 55]
Issuers of annual reports inaccurately stress the importance of the chairman's/president's letter. Annual report issuers consider the chairman's/president's letter to be the most important part of the annual report, especially for individual investors. Investors themselves, however, tell us that while they frequently read the CEO's letter, they rarely consider it important for decision making. [Also included in 1(b)] [SRI, p. 55]
Most individual investors do not know much about footnotes; many find them arcane and undecipherable. Even so, a slight majority (51.4 percent of those receiving annual reports) do "read" them. The only segment of individuals to ascribe a high level of importance to footnotes is the semiprofessional segment; 68.5 percent of them read the footnotes, and of those 60.0 percent consider them important. Furthermore, only about a quarter of all individual investors agree with the statement. "I have to read the footnotes to the financial statements to get an accurate picture of a company's performance" nearly half of the semiprofessionals agree with that statement. [Also included in 1(b)] [SRI, p. 55]
Professional investors, of course, are much much more knowledgeable about and place greater importance on footnotes. Most agreed with the statement, "I have to read the footnotes to the financial statements to get an accurate picture of a company's performance" (only 8.7 percent disagreed). Their ranking of footnotes as the third most important part of the annual report puts footnotes only behind the financial statements they explain, the income statement, and the balance sheet. [Also included in 1(b)] [SRI, p. 55-56]
Professional investors use annual reports for a variety of purposes in addition to investment analysis. Annual report issuers are certainly correct in their perception that annual reports are broadly based publications with many potential uses. [The] table [below] shows the degree to which the various types of professional investors use annuals for different purposes. All professionals use annuals as background and reference information. The brokers are more likely to use them in selling situations, while sell-side analysts and buy-side professionals are more likely to use them for analytical purposes. [SRI, p. 56-57]
Uses for Annual Report
Uses Sell-Side Buy-Side Retail Inst.
Total Analysts Professiona Brokers Sales
ls
General 96.2% 99.0% 92.4% 98.0% 98.0%
reference
Background
informatio
n
prior
to
meeting
with
company 88.5 97.0 90.7 68.0 87.0
management
Verifying
informatio
n
from 83.0 87.0 79.7 80.0 88.0
other
sources
Preparing 76.6 96.0 70.3 58.0 68.0
forecasts
Selling/di
scussing
with 57.1 64.0 28.8 78.0 86.0
customers
Industry
analysis
and
51.6 76.0 39.8 30.0 52.0
tracking
Making
presentati
ons
to
company
44.6 46.0 45.8 32.0 54.0
management
Source: SRI International Survey, 1986. [SRI, p. 56]
__________
Financial reports are important but not dominant providers of fundamental information [for sell-side analysts.] Discussions with management seem to user a most important source of information for analysts, although somewhat underplayed by them. Some analysts reports largely are transcriptions or summaries of a management presentation. One analyst reported on a "conference call" to discuss earnings with management and other analysts. Another reported on presentations and discussions at a company's annual meeting. [Also included in 1(b)] [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(a)] [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(a)] [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(a), 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(a), 1(b), and 3(e)] [PREVITS, p. 12]
Analysts aggregate [a variety of information] forecasts to form a company EPS forecast and to determine an appropriate price earnings ratio based upon the company's earnings momentum, growth prospects, earnings quality and stability, financial strength, and other factors. They then compute the product of the EPS forecast and the PE radio. If the current price is below the forecast price, they may recommend "buy"; if near a forecasted price they recommend "hold"; if above a forecasted price, they recommend "sell". The update of a recommendation may be precipitated by a change in management, a divestiture or acquisition or similar 8K event, or by the quarterly or more timely identification of reliable relevant factors. [PREVITS, p. 12]
[Sell-side] analysts may not believe that investors have lengthy horizons in assessing company performance. One analyst, for instance, stated: "We continue to rate these shares as neutral,. . . in the belief that investors are not yet ready to discount earnings growth 24 months in the future." [Also included in 1(d)] [PREVITS, p. 12]
Analysts tend to employ annualized data but [it is inferred] that they prefer more timely data whenever available. They employ a "rolling" four quarter analysis to annualize data as soon as the new quarterly data appears. Whether or not the issues related to so-called "4th quarter adjustments" taken at fiscal year end are properly anticipated is not clear. [Also included in 1(b) and 11(e)] [PREVITS, p. 12-13]
The effect of product changes or new products, even when not yet marketed, are almost always assessed [by sell-side analysts], particularly as to the company's ability to compete, and upon competing products, projected demand, revenue, and costs. [Also included in 1(b) and 13] [PREVITS, p. 14]
Major projects, including modernization, acquisition, expansion, divestiture, and restructuring plans are evaluated [by sell-side analysts], and their estimated effects are also used in forecasting future performance. Major expenditures on plant, property and equipment are evaluated, particularly in terms of product costing and capacity expansion. Downsizing plans, and plans to reduce the size of the labor force, are also addressed by the analysts. Analysts also report on the effect of share repurchase plans and planned issuances of new securities. [Also included in 1(b) and 13] [PREVITS, p. 14]
Phrases which focus on acquisition occur about 1,500 times in [sell-side analysts'] equity reports studied. Acquisitions are studied in several pro forma dimensions, including earnings and cash flow effects of financing the acquisition, the strategic fit, scale economics, and earnings contribution. [Also included in 1(b) and 13] [PREVITS, p. 14]
Finally, analysts use recent and proposed PP&E expenditure levels as a measure of the quality of the company's assets. They evaluate the effect of new contracts (particularly long term) and licensing agreements on EPS. [Also included in 1(b) and 13] [PREVITS, p. 14]
[Equity sell-side analysts'] attention . . . is given to revenue change, particularly as a result of product pricing, volume, and demand, and product mix. Production and sale volume information is analyzed. Expenses are only analyzed at a general level usually in terms of "margins", (c.4,200 times), or less frequently in terms of "operating costs", or "SG&A expenses." [Also included in 1(b) and 13] [PREVITS, p. 15]
[Equity sell-side analysts give] more detailed attention to noncapital expenditures sometimes . . . in the areas of research and developments expenditures, depreciation, materials and labor. Consistent with their general approach, analysts often estimate expenses by operating unit (segment) and sources of possible cost efficiencies are noted. Relative cost levels are compared across companies and management efforts to reduce costs are noted and evaluated. [Also included in 1(b) and 13] [PREVITS, p. 15]
Most [equity sell-side analysts] reports contain both historical and forecast quarterly and annual income statements or summary information. The most common approach to estimating future EPS is to disaggregate the company into its constituent LOB's and/or geographic regions (both of which are frequently more detailed than GAAP requires), and to then develop forecasts of the performance of individual units which are reaggregated for a company EPS estimate. [Also included in 1(b), 3(b), and 11(e)] [PREVITS, p. 15]
[O]perating revenues and expenses are often assessed [by equity sell-side analysts] for individual segments of a company. Performance analysis by significant product or individual location is common. For example, analysts may evaluate the performance of hotel companies in terms of specific U.S. or international geographic regions, or even specific hotels, while mining companies are evaluated in terms of individual mines. Similarly, consumer goods manufacturers are often evaluated in terms of their individual product lines or products. Some analysts carefully consider the effect on the entire company, industry, and economy as well as revenues and costs in forecasting the results for each reporting unit analyzed. [Also included in 1(b) and 3(e)] [PREVITS, p. 15]
A principal approach of many [equity sell-side] analysts for estimating a company's earnings per share involves the disaggregation of the company into as fine a set of reporting units as possible, followed by an earnings analysis and reaggregation. Segment related phrases appeared more than 20,000 times in the selected reports. This frequency was larger than any other grouping of related words and phrases except for income statement related phrases. Analysts use a variety of phrases to refer to the operating units of corporations, including "lines", "areas", "businesses", "divisions", "units", "segments", and "subsidiaries". [Also included in 1(b) and 3(e)] [PREVITS, p. 15]
[Equity sell-side] analysts employ a literal definition of nonrecurring income statement items, which are usually referred to as "one time" items. They take notice of reported nonrecurring items as listed below continuing operations and also note the effect of new accounting rules. One report contained a section entitled "Non-operating earnings - A Source of Confusion in the Past". [Also included in 1(b), 5(a), and 5(d)] [PREVITS, p. 15]
[Equity sell-side analysts] also identify "potential" nonrecurring items contained in continuing operations, and often report EPS net of these items, as in the case of the analyst who noted "several unusual items" included in continuing operations. Correspondingly, a number of analysts report operating earnings per share, which of course is not required under GAAP, or compute an "adjusted earnings" number which includes all items judged to be nonrecurring, and corresponding EPS. Restructuring charges are an example of one common item often removed in analysts EPS reports. Occasionally analysts identify a nonrecurring cost but are unable to estimate an amount. In one case an analyst was unable to determine the amount of a corporate relocation charge buried in continuing operations. In another report the relocation charge of the company was identified in continuing operations and removed in calculating EPS. [Also included in 1(b), 5(a) and 5(d)] [PREVITS, p. 15-16]
[Equity sell-side] analysts discuss a company's "earnings power" or "earnings momentum". One report, for example, commented on a firm's "strong accelerating growth". This appears to be something different than the earnings growth rate reported, which is linear, and suggests a nonlinear growth component. [Also included in 1(b)] [PREVITS, p. 16]
The "stability" of a company's earnings is addressed by [equity sell-side] analysts who frequently assess the degree of uncertainty of future earnings, often in terms of "risk". Analysts do not, however, provide explicit evidence that they identify discretionary accruals of management to smooth income. One the other hand, as noted in the discussion of "earnings quality", analysts are attentive to some accruals. [Also included in 1(b) and 10(d)] [PREVITS, p. 16]
[Equity sell-side] analysts define "earnings quality" differently than [was] expected. To financial analysts, a company with high earnings quality is one that uses very conservative accounting principles; for instance a company that has accrued reserves against future losses, write downs, etc. One analyst, for instance, reported earnings quality as high when a firm had an "aggressive" policy towards establishing reserves. Another substantiated an assertion of high earnings quality for a company by stating that "the company is over-accruing foreign taxes as a way of managing earnings." A third supported its assertion of high quality earnings by noting that "the opportunity to 'manage down' earnings exists". A fourth argued that a financial company's earnings were more 'credible' because the company applied "more aggressive accounting" methods in writing down assets. [Also included in 1(b) and 5(a)] [PREVITS, p. 16]
This suggests a possible analyst preference for secret reserves. [Also included in 1(b) and 5(a)] [PREVITS, p. 16]
[Sometimes,] earnings quality . . . seem[s] to be related to "representational faithfulness," and management's forthrightness in disclosure. For example, one analyst reported that an extreme drop in the reported tax rate of a company "caused some to doubt the quality of (its) earnings". Another expressed concern about earnings quality on the basis of the amount of costs included by a company in the determination of cost of goods sold. [Also included in 1(b), 2(b) and 5(a)] [PREVITS, p. 16]
Other income analysis factors:
- Analysts see a "strategic acquisition" to be one which reduces a company's short term earnings but increases longer term earning potential.
- Analysts report sale backlog (at company or operating unit levels) and use these as a basis for estimating future performance.
- Average tax rates are calculated for most companies with income data on a comparative and trend basis. Current and deferred portions of income tax expense are often disclosed.
- Regulated companies reported "statutory" or regulatory income compared with GAAP income. [Also included in 1(b) and 5(a)] [PREVITS, p. 16]
The balance sheet receives far less attention than the income statement [by equity sell-side analysts], and the occurrences of balance sheet type words and phrases occur far less frequently [in analysts' reports]. Much of the attention to balance sheet items comes in the form of liquidity and cash flow analysis. For example, reports may assert balance sheet strength on the basis of a company's free cash flow. While several income statements are almost always presented, many reports contain only summary balance sheets [Also included in 1(b), 5(b), and 5(c)] [PREVITS, p. 17]
Long term productive asset values on the balance sheet are nearly always evaluated at cost [by equity sell-side analysts]. The effect of inflation on such assets rarely is explicitly considered. However, for some companies, a supplemental analysis of assets' market value is conducted. This is undertaken for firms analysts consider to be poorly understood by other analysts and investors, and particularly where latent significant off-balance-sheet or hidden assets may exist. [Also included in 1(b), 4, and 5(b)] [PREVITS, p. 17]
[A]nalysts asserted that a cable television company had substantial off-balance-sheet assets in the form of residual payments to be received in the future. They calculated the value of the company using several methods, one being the present value of the anticipated cash flows from these residuals. One analyst stated that "balance sheet recognition of . . . hidden asset values . . . will occur in future years". Other examples include inventory and reserve valuations of extractive industry companies. For instance, in gold mining companies, a market value appraisal is included of the reserve values by ore type. [Also included in 1(b), 4, 5(b), and 5(c)] [PREVITS, p. 17]
[Equity sell-side] analysts periodically examine the quality of assets, particularly in troubled industries such as banking and insurance. Here, attention is paid to nonearning assets, non-performing assets, and the quality of assets (loan portfolios) and investments. [Also included in 1(b) and 5(b)] [PREVITS, p. 17]
Liabilities are usually addressed in a summary fashion, often in a simple analysis of the capitalization of the corporation. Extensive attention to liabilities usually only occurs for companies that are highly leveraged and typically in conjunction with a cash flows analysis. [Also included in 1(b), 5(b), and 5(c)] [PREVITS, p. 17]
Cash flow analysis [by equity sell-side analysts] displays considerable variety in format and content. Many reports present and/or discuss cash flow extensively. Cash flow information is sometimes presented by segment or operating unit. Some reports make no mention of cash flow at all. Cash flow type phrases occurred about 6,000 times in the full sample. [Separately, dividends are mentioned over 2,000 times.] [Also included in 1(b), 3(c), and 5(c)] [PREVITS, p. 18]
Although cash flow per share calculations are not permitted in audited filings under SEC rules nor by SFAS 95, cash flow per share and operating cash flow per share are almost always calculated by analysts when they provide any cash flow data. Analysts also calculate "fully diluted cash flow per share" and some provide "distributable cash flow per share", "excess cash flow per share", "discretionary cash flow per share", and "free cash flow per share." [Also included in 1(b) and 5(c)] [PREVITS, p. 18]
Some [equity sell-side] analysts compute a price to cash flow ratio, and present a comparison of this ratio with other companies in that industry. Others assess the relationship between cash flows and earnings. For example one report stated that the value of a company was "compelling" because "operating cash flows are 4.3 times 1990 earnings". Another analysts encouraged purchase of a major tobacco company's stock because of its "tremendous surplus cash flows". [Also included in 1(b) and 5(c)] [PREVITS, p. 18]
Cash flows seem to be more important to [equity sell-side] analysts in evaluating smaller companies, and less so in evaluating larger companies, with the exception of highly leveraged larger companies or ones in which a dividend cut is possible. One report, for example, states that "The important figure . . . for evaluation of smaller petroleum . . . companies is operating cash flow per share." Another stated that in comparison with cash flow "historical financial results of [the company] are irrelevant". [Also included in 1(b) and 5(c)] [PREVITS, p. 18]
Examples of unorthodox cash flow formats [presented by equity sell-side] analysts in addition to free cash flow and discretionary cash flow arrangements are:
Net income
+/- all effects except cash interest
= cash flow available to common
- cash interest
= net cash flow
Direct operating cash flows
- priority outflows
- discretionary outflows
+ financial inflows
= change in cash
[Also included in 1(b) and 5(c)] [PREVITS, p. 18]
It was also intriguing to discover an example where the "foreign exchange cash flow" in a statement of cash flows was presented outside the three traditional categories of the SFAS 95 format. [Also included in 1(b) and 5(c)] [PREVITS, p. 18]
[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(a), 1(b), and 4] [PREVITS, p. 19]
Another 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(a), 1(b), 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(a), 1(b), 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(a), 1(b), and 4] [PREVITS, p. 19]
__________
[Context] The AIMR 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(a) and 1(b)] [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(a) and 1(b)] [AIMR/FAPC92, p. vi]
[Context] Those two paragraphs introduce the following excerpts and relate them to excerpts from the same section included in 1(a)-Investors' and creditors' objectives and approaches and 1(b)-Types of information that investors and creditors use . . . .
Distinguishing Financial Analysis from Financial Reporting
It is quite easy to make a conceptual distinction between financial reporting and financial analysis. Although both result in expressions of worth or value, their perspectives are diametrically opposed. Financial statements express net worth as the surplus of total assets over total liabilities. Assets and liabilities are both the result of past transactions and events, thus so is the accounting measure of net worth. Financial analysis, on the other hand, assesses, estimates and gauges value solely in terms of expectations of the future. A standard concept of value is that embodied in the dividend discount model (DDM), described above as postulating the value of a security to be the present value of its expected future dividends plus its estimated residual price at some specified future date, discounted at a risk-adjusted rate of return (opportunity cost of capital). Thus financial analysts seek to prognosticate the amounts, timing and risk attached to a firm's future cash flows, either directly or through surrogates, such as earnings forecasts. [Footnote reference omitted.] [AIMR/FAPC92, p. 8]
Statement of Financial Accounting Concepts No. 1, "Objectives of Financial Reporting by Business Enterprises," states in paragraph 37:
Financial reporting should provide information to help present and potential investors and creditors and other users in assessing the amounts, timing and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption or maturity of securities or loans. The prospects for those cash receipts are affected by the enterprise's ability to generate enough cash to meet its obligations when due and its other cash operating needs, to reinvest in operations, and to pay cash dividends and may also be affected by perceptions of investors and creditors generally about that ability, which affect market prices of the enterprise's securities. Thus, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective cash flows to the related enterprise. [AIMR/FAPC92, p. 8]
A footnote to paragraph 37 explains that the objective "neither requires nor prohibits `cash flow information,' `current value information,' `management forecast information,' or any other specific information." Statement of Financial Accounting Concepts No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises," on page 5, limits measurement in accounting to the financial statements themselves. [AIMR/FAPC92, p. 9]
The question then arises as to the proper relationship between: (a) financial statements; (b) notes to financial statements, supplementary information, and other means of financial reporting; and (c) financial analysis, which according to Statement of Financial Accounting Concepts No. 5 falls outside of financial reporting. To what extent should assessment of the amounts, timing, and uncertainty of an enterprise's future cash flows fall into each of those three categories? [AIMR/FAPC92, p. 9]
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. It is self-evident that reporting on the past always requires the use of estimates and other assessments of future events: uncollectible receivables, depreciable lives, warranty repair costs, and the like. Forecasts of the future and similar material enhances financial report usefulness, but must be separated from and not confused with the financial statements themselves. Financial analysts avidly seek management's forecasts as part of the financial reporting process, accompanying but not incorporated in the financial statements. [AIMR/FAPC92, p. 9]
Financial analysts, in turn, have the task of digesting all relevant economic information that can affect an economic entity, including but not limited to its financial reports. 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. Allocation decisions are made primarily on the basis of comparisons. [AIMR/FAPC92, p. 9]
Financial reporting and financial analysis cross paths because, ultimately, economic value (wealth) is created by expectations of future inflows of economic benefits, primarily in the form of or the equivalent of cash flows. The amounts and timing of future cash flows are in most cases uncertain to various degrees. It is the function of analysis to deal rationally with that uncertainty. It is the function of financial reporting to provide data useful to analysts making assessments of an enterprise's future cash flows and its value today. Such data include detailed and up-to-date information on the amounts and timing of past cash flows, periodic wealth increases from operating activities (profitability), economic status at regular past intervals, together with an abundance of supplementary data necessary to understand their content and significance. [AIMR/FAPC92, p. 9]
Some persons may confuse the roles of financial reporting and financial analysis because of the function of forward-looking information, which is essentially of two different types. First are amounts that we expect to see reported in financial statements and subject to audit: receivables, payables, a variety of financial instruments reported at the present value of their future cash flows. These are contractually-determined amounts arising from past exchanges that meet the definitions of assets or liabilities, even though their value may properly be determined by the amounts of related future exchanges. The other type of forward-looking information comprises forecasts, projections, and certain pro-forma presentations. These numbers are of great importance and usefulness to analysts, but they are not part of the economic history of the firm and therefore not proper financial statement components. Nor are they auditable, although the participation of an independent accountant in their preparation could well enhance their credibility and "user-friendliness" as well as provide some assurance that management's methodology was sound, its assumptions reasonable, and its calculations accurate. [AIMR/FAPC92, p. 9-10]
How Financial Reporting Can Serve Financial Analysis
The starting point in analysis of a specific company is to look at the record. How has that management and company performed in the past and what is its status at present? Answers to those questions are found in the company's financial statements. Past performance is evaluated in terms of profitability and liquidity, current status in terms of financial position. Financial statements are valuable to the extent that they provide useful and comprehensive information that allow financial analysts to evaluate how well management has done with the resources at its command. Although the word "stewardship" no longer is fashionable, it fits here. In fact, it continues to be a major reason for the accounting profession to continue producing financial statements in their traditional format. [AIMR/FAPC92, p. 10]
The specific content of financial statements is discussed in more detail in other sections of this report, but it is important here to state how essential it is that the financial reports should be comprehensive. If we are to have financial statements in the traditional form, they ought to include what they purport to contain. For example, many so-called "off-balance sheet" items should be on the balance sheet. Another matter on which all analysts are agreed is the urgent need for the FASB to develop, in the form of financial accounting standards, the notion of "Comprehensive Income" that it introduced in Concepts Statements Nos. 3 and 6. If done properly, such standards would bring back to a structured income statement various items that now bypass income on their way to the owners' equity section of the balance sheet. The topic of comprehensive income is discussed at greater length later in this report. [AIMR/FAPC92, p. 10]
Analysts need financial statements structured so as to be consistent with how the business is organized and managed. That means that two different companies in the same industry may have to report segment data differently because they are structured differently themselves. Perhaps one may be organized by product line, the other by geographical area, or by the types of industries represented by its customers. There are even more possibilities of organizational differences between and among companies in different industries. Some may be production oriented, others driven by markets or research activity. We also are aware of the difficulty of setting accounting and disclosure standards to meet our needs and our more detailed topical discussions later in this report incorporate that concern. [AIMR/FAPC92, p. 10]
Financial reports have to be understandable. Analysts are quite aware of the technically demanding nature of certain accounting standards and we sympathize with financial statement preparers and their auditors for the additional work they must do. However, these standards were promulgated because they are intended to provide vital economic information to investors, creditors and other financial statement users. We worry that the purpose of a standard can be thwarted by a grudging compliance with only its technical requirements. We look in financial reports for information -- and often its provision requires explanations that go beyond the bare minimum reporting requirements contained in a standard or checklist. [AIMR/FAPC92, p. 11]
The financial reporting process is most useful when it goes beyond the past and present to include management's views of its future strategies, plans and expectations. For example, currently management is required in the Management Discussion and Analysis (MD&A) section of its annual report to shareholders to report how the results of each of the past three years differ, one from another. The SEC strongly encourages, but does not require similar discussion of how management expects the results of future years to differ from those of the past. Why have managements been so slow to respond to this urging? We have seen some improvement recently, but the pace is glacial. [AIMR/FAPC92, p. 11]
Financial reports also should provide assurance that the organization is under control. At one extreme, that means that it conducts its affairs at least lawfully and (we hope) ethically in all the jurisdictions and cultures in which it operates. In another sense, we seek assurance that the company is being operated in the interests of its shareholders and creditors for the purpose(s) asserted to them and with the goal of maximizing their wealth in a responsible manner. We expect business firms not to contribute to social injustice or environmental degradation, although individual analysts have different concepts of how these politically sensitive goals can best be achieved. What all analysts need is a depiction of what the enterprise is doing in these areas as well as assurance that control systems to ensure continued compliance are in place and operative. We also believe this is an area for expanded activity by internal and independent accountants. [AIMR/FAPC92, p. 11]
__________
Finally, we note that mark-to-market accounting is intended to apply to individual assets and/or liabilities, either singly or in portfolios of homogeneous components. Despite our overall opposition to its imminent adoption, we consider it to be appropriately within the domain of the accounting function. On the other hand, when it comes to the valuation of business enterprises, either singly, in groups, or by components, we rightfully regard that as the province of financial analysis and a matter beyond the scope of financial reporting. [Also included in 4] [AIMR/FAPC92, p. 29]
__________
[Context] Meeting of the Investor Discussion Group on October 16, 1992. When discussing their basic objectives and approaches to evaluating equity securities, some investors referred to the way(s) they use the information provided in external reports to achieve their objectives.
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(a) and 1(b)] [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(a) and 1(b)] [TI 10/16, p. 5-6]
__________
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(a)] [TI 10/16, p. 7-8]
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(a)] [TI 10/16, p. 8]
__________
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(a)] [TI 10/16, p. 13]
[Context] Meeting of the Investor Discussion Group on October 16, 1992. After discussing their basic objectives and approaches to evaluating equity securities and the types of information they use to achieve their objectives, investors were asked the following questions on the ways they use the information:
Do you standardize your process for analyzing the mass of information?
Do you have a sequential process; do you have a routine; what do you go through?
Does every analyst and manager have the freedom to analyse the information in any way they want?
Participant I-7
On all the companies that I cover, I have a model. The complexity of the model depends on the size and the diversity of the company. The model may be no more than an annual historical P&L representation, an historical quarterly, and also a forecast of the current year and the subsequent year. [TI 10/16, p. 49]
To the extent that the companies I follow provide us with some FAS 14 disclosures, I will incorporate in my model an attempt to tie the segmented earnings numbers to my annual and quartely model for the whole company. Increasingly, I have started for larger companies to make an attempt to project some kind of growth rate by business segments for the next 3 to 5 years. [Also included in 3(e)] [TI 10/16, p. 49-50]
Participant I-12
I don't bother building models for any company that is in a high risk area. A lot of people in the business right now would say don't touch [name deleted] because a third of their loans is in real estate in California. So why make the effort of building a model for a company like that? I do a screening process that is more intuitive than anything else and when I get to building a model, I do a P&L model, selective balance sheet items, and I typically will project out for 3 to 5 years on a worse and best case scenario. [TI 10/16, p. 50]
Participant I-6
I start with all the details and do a "bottoms up" and that is easier with a basic industry company than a financial company. Even though there is a lack of data, the FAS 14 disclosures of some companies is fairly decent annually. I will look at the production by mine, by plant if I can get it, then I will build up the unit side of the equation and then multiply that by our expectation of the unit selling price to get a revenue-driven model. When we can, we break down the various cost components and forecast those. The production data feeds the income statement, feeds the cash flow statement, feeds the balance sheet, which feeds about 15 standard ratios that we use. You look for variations in those ratios each quarter or each year. That's the methodical part that takes very little of your time. That's where you start. [Also included in 3(e)] [TI 10/16, p. 50]
Participant I-8
I think we are all the same. It depends on the nature of the company you follow. You're looking for the gross margin and what the pattern has been, R&D as a % of sales, and whatever detail you can get. So you have 2 things that it gives you: what has been the historical pattern within the company and how the company and its ratios compare to other companies. [TI 10/16, p. 50]
Participant I-9
We start with the annual report and that suggests questions. Then I go see as high a person in the company as I can and try to get the sales and objectives of the chairman of the company and see if that makes sense in relation to the profitability of the business and the trends in the industry and identify the key areas that are crucial. Then you monitor that very closely and get conviction. If there is a new development, you call an analyst on the street or call the company, and read the financial statements of the company, to see if you should adjust your projections. [TI 10/16, p. 51]
Participant I-1
We try to overlay a lot of qualitative factors, particularly in terms of change; we are real change junkies. If something is going to stay the same, we can't bring much value-added in, the market is efficient, so we are wasting our time. We try to identify change catalysts in one form or another, then we will build our model based upon that. Then, we run a fair amount of sensitivity off of it; we're downside oriented or concerned. So we're looking at the worse case scenario. [TI 10/16, p. 51]
Committee/Staff/Observer
What kinds of statistical information do you routinely prepare from the financial and nonfinancial information that you have identified? Do you routinely prepare ratios and % and what are they? Give us some specific examples. Do you have a standardized list of ratios and %? Implicit in that is that if you do, perhaps they should be included in our product automatically? [TI 10/16, p. 51]
Participant I-6
A couple of simple ones: book value, debt ratios. Trying to do the book value is difficult on a company based on their quarterly numbers. First of all, most companies don't report actual shares outstanding, they give the average for the quarter; that doesn't help you get a book value number. Debt ratios: every company that I follow has its own little twist to it. I think the value that the accounting profession could bring is some standardized ratios that would be reported and audited on an annual or quarterly basis and have very specific definitions for those ratios. [Also included in 11(c), 13, and 17(b)] [TI 10/16, p. 51-52]
Participant I-3
Because the companies that I follow even in the same industry don't report their financial information in a comparable manner, I look at a lot of productivity and cost relationships. Obviously, I can't get them from the reported information. It also helps me understand the dynamic changes within an industry and the relative abilities of companies to operate in very competitive industries. [TI 10/16, p. 52]
Participant I-8
The accounting concept of materiality is of concern to me. What is perhaps by definition not material, I've heard 5% or 10% or whatever is being reported, can be a 150% of some increment that we're looking at (earnings, gains, or whatever) and somebody had to reconcile the accounting and financial analysis notions of materiality. [TI 10/16, p. 52]
Participant I-7
I have about 20-25 pages of historical ratios on the companies that I follow within my industry. I put them on a least squares basis (annual) to offset the starting and ending point. [TI 10/16, p. 52]
Participant I-11
The only trouble is that you can't do a log linear regression when you have loss periods. I do agree though that for most industries, there is enough static from year to year that if you just look at a start point and an end point, you can come up with a really misleading number. The things that are important to you as an analyst depend heavily on what kind of industry you're analyzing. Maybe it boils down to say that in every industry there are certain key ratios and certain key data that management use to run and measure their business. To the extent possible, we would like to have access to those measurements. Taking the wholesale distribution as an example, a couple of key measures are average order size and average line items per invoice. It would be useful to me to make predictions to have access to those figures. [TI 10/16, p. 52-53]
Participant I-7
I'm interested in knowing the ratios, the information that you look at from an internal point of view providing it is not going to hurt your business position. I want that information. [Also included in 13] [TI 10/16, p. 53]
Participant I-1
Any company which depends upon bids for its business will generally issue a backlog list; the only thing you can track as an externalist is what they publish as a rolling backlog and you have no concept of what kind of margins they bid those contracts at until 18 to 36 months later when it flows to the income statement. [Also included in 13] [TI 10/16, p. 53]
Participant I-7
I had that exact situation where a company in the capital goods industry had an earnings problem and we missed it because, in the prior 6 months, they had taken business in the backlog with a narrow margin. I know that at the plant level that information is available and that should not have happened. [Also included in 13] [TI 10/16, p. 53]
Participant I-1
On the one hand, as investors, we want to know immediately how they bid on that contract. On the other hand, they will argue vehemently that it is a highly competitive industry and they can never give away what the margins were for contracts because they may have a strategic reason on a given contract. I don't know how you balance that out in a particular industry. [Also included in 13] [TI 10/16, p. 53]
Committee/Staff/Observer
This relates to projected information. Do you prepare cash flows, earnings statement, balance sheet on a projected basis? If so, in what degree of detail? For how many future periods? [TI 10/16, p. 54]
Participant I-6
I go into as much detail as I possibly can get and that usually is quarterly by segment: income statement, cash flow, I don't do that much on the balance sheet, definitely the equity section and maybe the debt section. Quarterly for the current year and the next year, and then annually for at least 5 years. [Also included in 3(e) and 11(e)] [TI 10/16, p. 54]
Participant I-1
We used an integrated sort of hybrid LBO model which has income statement, balance sheet, and cash flow statement. We run it out the full 10 years and cut the last 5 as being worthless. We try not to get into quarterlies because it distracts us from our long-term orientation. [Also included in 11(e)] [TI 10/16, p. 54]
Participant I-11
We also do quarterlies for the current and next fiscal year, so somewhere between 5 and 8 quarters of estimates at any one time. On the P&L, typically in the format that the company presents the data. We will do detailed cash flow analyses over that period if it looks like there is a cash flow issue to be addressed, but not as a matter of course. [Also included in 11(e)] [TI 10/16, p. 55]
Participant I-5
It varies. There is one company that I never projected a single number for that we recommended. And there have been companies where you have to go out 5, 7 or 8 years. [TI 10/16, p. 55]
Committee/Staff/Observer
Let's talk about the company you recommended with no projection for. How and why? [TI 10/16, p.55]
Participant I-5
It was a debt instrument with a balance sheet-driven story and a company whose results were flatish on a cash flow basis. The balance sheet, on the other hand, had $60 million of cash, $40 million of debt, and the debt was trading at $.25 on the dollar, yielding 25%. [TI 10/16, p. 55]
Participant I-6
In the mining industry, you have to project your operating data. As I said two hours ago, we lack good operating statistics in the U.S. We get much better operating statistics overseas. I start with the basic output of each mine to get down to how much they are going to earn in that quarter. [Also included in 13] [TI 10/16, p. 55]
Participant I-12
You should try getting operating data for financial companies. How many loan customers do you have? What is the average balance? What I have done is find out all kinds of data sources and created a rather weird model for interpolating those kinds of things and making estimates going forward about potential growth rate for given geographic areas. But it's a lot of work but if we're in a world of low inflation, that unit growth of number of customers is going to be critical in this particular industry. That's one area where financial companies under-report comparative to industrial companies. [Also included in 13] [TI 10/16, p. 56]
Committee/Staff/Observer
We talked about projected financial information that you all make and I think it is almost a consensus that you're projecting primarily income statement-type information for 2 years to maybe as many as 5. Can you help us understand how you then take those projections and convert them into a stock price? [TI 10/16, p. 57]
Participant I-2
I look at a relative multiple compared to the S&P 500. If you go back to a very high interest rate period, maybe the relative multiple to the S&P is none and just before the 1987 crash, it was maybe 18. [TI 10/16, p. 58]
Committee/Staff/Observer
Would you adjust the multiple if you thought that the company has great prospects beyond year 5? [TI 10/16, p. 59]
Participant I-2
Yes, it's a dynamic situation. Some companies have a small denominator and grow rapidly but when the denominator gets bigger, they grow very slowly. So you would be inclined to be edging your relative multiple down. Other companies have a new product cycle or there is a rapid growth in a new business, then you tend to increase the multiple. It's much more important to look at relative multiples than at absolute multiples. [TI 10/16, p. 59]
Committee/Staff/Member
Most of you are using multiple of earnings rather than discount of future earnings? [TI 10/16, p. 59]
Participant I-9
It takes 3 to 5 years to train a security analyst. How much you pay them depends on how they use the information and it's not rational. Engineers and accountants usually want to have a system where 2 follows 1 by the same distance that 3 follows 2 and that's not the business we're in. [TI 10/16, p. 59]
Participant I-12
I use price to adjusted book value in addition to relative P/E. Book value can be adjusted for a number of things. First, you have to add in the future cash flows that you have estimated and then you look at market price and all the black box process that we analysts do. But I adjust book value for earnings factors and for cyclical factors to arrive at a ratio that I can then apply to my adjusted book. [TI 10/16, p. 59]
[Context] Responses to the postmeeting questionnaire to the October 16, 1992 Investor Discussion Group meeting.
QUESTION 2
We understand that investors who use the fundamental approach to equity security analysis generally determine the intrinsic value of an equity security and the underlying company by:
(a) Applying a multiple to their predictions of the company's normalized or core future earnings
(b) Discounting at a risk adjusted rate of return their predictions of the company's future cash flows, future dividends, or future earnings
Do you know of an other way that is used to determine intrinsic value?
Yes (see descriptions below) 6No 3
Descriptions of other ways to determine intrinsic value:
Participant I-4: Applying appropriate cap-rates to projected cash flows gives a more complete picture of business value; assume one is buying the entire company not just equity securities
Participant I-9: (1) Break up value, (2) Merger value--i.e., synergistic benefits such as cost savings, selling more products through a combined sales force, (3) current yield relative to short-term money rates & U.S. treasury note yields.
Participant I-17: For companies with diverse operations, there could be "hidden" value in one division that is obscured by the operations of the overall company. In this case, evaluation of each individual operation (i.e., the parts are worth more than the whole) would be most relevant.
Participant I-8: A company, for example, can have two parts. One nicely profitable and an offsetting unprofitable business. In such a case, the intrinsic value would be a valuation of the good business as described above plus an estimate of the value of the poor business to a competitor.
Participant I-11: In some cases, estimating the current or future "real" value of the company's assets (i.e., the economic value of raw material reserves for a natural resource company).
Participant I-12: Assessing realizable book value per share and applying some premium or discount to reflect current and/or expected growth in that book value - works better for financial rather than industrial companies.
a. Regarding investors who apply a multiple to their predictions of the company's normalized or core future earnings:
We understand that most professionals in the investment community apply a multiple to their predictions of the company's future earnings.
Does that agree with your experience?
Yes 9
No 0
How far into the future do those investors predict earnings?
Quarters for the current year 7 Quarters for the following 4 year: Annual earnings for the 8 following year Annual earnings for years 3 to 9 5 Growth rate of earnings for 7 years 3 to 5 Annual earnings beyond 5 years 0
How do those investors determine the multiple?
A historical P/E ratio for the company 5 The historical relationship between the company's P/E ratio and the P/E ratio for the market, sector, or industry 5 The current P/E ratio for similar companies 6 An estimated P/E ratio based on factors such as common stock prices, earnings, growth, risk, time value of money, and dividend policy that are weighted on the basis of their or their colleagues' professional judgment 2 An estimated P/E ratio based on factors such as common stock prices, earnings, growth, risk, time value of money, and dividend policy that are weighted by the use of regression analysis or other statistical process? 2
Other Description
Participant Probably all of the above with varying success--I
I-4 think the answer (correct) is closest to the
[estimated P/E ratio based on factors such as
common stock prices, earnings, growth, risk, time
value of money, and dividend policy that are
weighted on the basis of their or their
colleagues' professional judgment] although the
answer creates an entirely new book of questions
regarding one's interpretation of risk, etc.
Participant And, at any point in time, a judgment of whether
I-17 those earnings are in fact "normal," "peak," or
"trough."
Participant My way. Base a multiple expectation on company's
I-8 return on equity and return on assets relative to
the market and as a whole and its projected
multiple out three years and also have an opinion
on the company's reinvestment opportunities beyond
three years.
Participant I look at the current P/E and then try to decide
I-9 whether it will move up or down based upon both
current fashions in the stock market and by trying
to determine what future fashions will be.
Participant One generally needs to make a judgment about the
I-10 market's P/E in order to go from relatives to
absolutes.
Participant I have seen each of these approaches used,
I-11 depending on the investor and on the facts and
circumstances of the case.
Participant Estimated P/E ration based on general economic
I-12 conditions combined with company/industry market
factors listed above.
b. Regarding investors who discount their predictions of the company's future cash flows, future dividends, or future earnings:
Do you discount at a risk adjusted rate of return your predictions of future cash flows, future dividends, or future earnings?
Yes 3
No 6
Participant I-9: I do not use a discounted rate of return method. For periods beyond 3 years it is too hard to predict both earnings growth with conviction and the discount rate which depends upon both psychology and the level of interest rate. I have found this method consistently over values stocks with high current year growth rates. It is usually an inertia forecast using current growth and current interest levels.
If not, do you know of someone who does?
Yes 2
No 3
If you answered "Yes" on either of the two preceding questions, please continue with the following questions:
Do investors who discount at a risk adjusted rate of return most commonly discount:
Cash flows? 3
Dividends? 0
Future earnings? 3
Do investors who discount cash flows usually derive cash flows from earnings by adding net noncash expenses?
Yes 5
No 0
How far into the future do they predict cash flows, dividends, or earnings?
Six to twelve months 0 Twelve to eighteen months 1 Eighteen months to two years 2 Two to four years 5 Five years 2 Beyond five years 0
Please describe how they determine the discount rate.
Participant I-4: Art form--developed through an individual's
analysis of relative risk of future cash flows vs. relative
certainties now known.
Participant I-17: 1) Take the expected rate of return for the
market
2) Subtract the 1 year T-Bill rate from that expected rate
3) Multiply that figure by the stock's beta
4) Add that figure to the T-Bill rate
Example: Expected Market Return 12%
- T-Bill Rate (riskless rate of return) 4%
Equity Risk Premium 8%
X Individual Stock Beta (1.25) 10%
+ T-Bill Rate 4%
= Discount Rate 14%
Participant I-10: I believe the discount rate requires: a) risk
free rate, b) growth of co., and c) a desired return above the
risk free rate. Method is very sensitive to small changes.
Participant I-11: Generally, they add some risk factor to the
current (or expected) "risk free" rate--i.e., T-bills.
Participant I-12 Most analysts use Treasury bond rates and add
back some personally derived risk factor. Others impute a "cost
of capital" based on core earnings divided by the stock price.
Practice varies widely- any basic finance textbook could probably
provide some basics.
[PMQI 10/16, p. 2-7]
QUESTION 7
What kinds of statistical information do you routinely prepare from the nonfinancial and financial information available? For example, do you routinely compute:
Ratios and percentages that help you assess relative profitability, productivity, and risk?
Yes 9
No 0
Statistics that measure changes over time, such as annual growth rates?
Yes (see descriptions below) 9
No 0
Descriptions of statistics that measure changes over time:
Participant I-4: Change in cash flows, values of certain assets, corp. value change
Participant I-17: Annual growth rates-next two years, P/E ratios-next two years, P/E ratios vs. estimate of "normalized earnings"
Participant I-10: Capital reinvestment rates
Participant I-11: Annual sales growth rate, annual earnings growth rate, annual dividend growth ratios
Participant I-12: Five year compound annual growth in earnings, assets
Do you have a standardized list of statistics that measure changes over time?
Yes (see descriptions below )9
No 0
Description of other statistics that measure changes over time:
Participant I-6: Trends in costs, trends in selling prices, CAGR in volumes
Participant I-7: Pricing, SGA, cost-of-good, ROE, ROA, cash flow
Participant I-11: Sequential/seasonal patterns of change, incremental profit rates
Participant I-12: The list varies with the economic cycle- emphasis on credit quality when the economy worsens and growth when it recovers.
Questions on ratios and percentages that help you assess relative profitability, productivity, and risk:
Question 1: Please indicate the relative significance in your work of the ratios and percentages listed in the table on the next page by checking whether you find each Essential, Helpful, Merely Interesting, or Not Useful.
Question 2: Do you have a standardized list of ratios or percentages?
Yes 8
No 0
Merely On
Inter- Not Your
Essential Helpful esting Useful List
Current current assets 2 5 1 1 2
ratio: current liabilities
Quick or current assets - 1 4 3 1 1
acid test inventories
ratio: current liabilities
Inventory sales 5 2 1 1 4
turnover: inventory
Accounts sales 1 4 2 2 1
receivables net accounts
turnover: receivables
Average receivables 3 4 2 1
collection sales/360
period:
Question 7 (continued)
Merely On
Inter- Not Your
Essential Helpful esting Useful List
Fixed assets sales 3 2 2 2 2
(plant & plant & equipment
equipment)
utilization:
Total assets sales 5 1 1 2 2
utilization: total assets
Long-term long-term debt 5 4 4
debt to stockholders' equity
equity:
Total debt currrent liabilities 3 3 2 1 2
to equity:
+ long-term debt
stockholders' equity
Debt to total debt 2 3 3 1 1
total assets: total assets
Times earnings before 3 5 1 3
interest interest and taxes
earned: interest expense
Expenses to expenses except 4 1 3 1 3
revenues income taxes
ratio: sales
Profit earnings 7 2 5
margin: sales
Return on earnings + interest 7 2 4
total assets: expense-tax
benefit of interest
expense
total assets
EBIT return earnings before 4 4 1 4
on assets: interest and taxes
assets
Return on earnings available 8 1 6
equity to
common stockholders
number of common
shares outstanding
Earnings per earnings available 9 6
share (EPS) to
common stockholders
common stockholders'
equity
Dividends dividends paid on 7 2 6
per share common stock
number of common
shares outstanding
Payout cash dividends per 3 6 4
ratio: share
earnings per share
Price market price per 8 1 6
/earnings share
ratio: earnings per share
Book value stockholders' equity 6 2 1 5
per share: number of shares
outstanding
Question 7 (continued)
Merely On
Inter- Not Your
Essential Helpful esting Useful List
Cash flow earnings available 5 2 2 4
per share: to common
stockholders +
noncash expenses &
write-offs
number of common
shares outstanding
Others:.
Fully Diluted
Total Market (# shares x price) 1
Value plus debt
annual sales
Gross profit 1 2
margin
SGA as a 1 2
percentage of
sales
Research as a 1 1
percentage of
sales
Operating 1
profit margin
Tangible book 1 1
value
Total debt/ 1 1
tangible
equity
Net Interest Int Income - Int Exp 1
Margin Avg. Earning Assets
Non-performing Past due 90 days + 1
assets Other real estate
owned
Avg loans + other
real estate owned
Liquidity Market Related 1
Ratio Liabilities
Total Funding
Charge-off Net Charge-Offs 1
Ratio Average loans
Efficiency Non-interest Expense 1
Ratio Total revenue (net
of interest expense)