As I wrap up the current earning season, I find that my confidence in reported numbers doesn't increase. Inaccurate representation about current business operations and future prospects keep showing up in corporate earnings reports.
A company's management has the implicit responsibility to accurately and truthfully report the details about the business. What happened in the business operations in the prior quarter? What are the positives and What are the negatives? What are the challenges and opportunities? All of these should be laid out in a simple and clear manner. A company's management is in partnership with its shareholders. Thus, both should know the same facts and prospects about the business.
The most egregious areas of representation crisis have occurred in management's future guidance about the business in general, and in the depiction of the true profitability and cash flows of the business.
In guiding the future business financials, companies seem to inherently stretch their “vision”, especially when it comes to projecting the long-term financial. Future earning numbers are important because they affect a company's market valuation and a lot of investors use the forward Price to Earnings ratio to gauge how cheap the company is priced in the public markets. Thus, putting a future number around that earning allows a company to indirectly impact its market valuation. Some companies can use this technique to inflate their stock prices or use the artificially inflated stock as a currency to do bad acquisitions. This atrocious behavior doesn't stop there. Internal company employees have been manipulating accounting entrees to meet the guidance or wall street estimates. Thus, we see a restatement of financial statements.
In providing future guidance, or relying on wall street estimates, the companies and investors are ignoring the reality that businesses are like "live" entities that get affected by multiple forces of capitalism. Thus, predicting the future is not easy.
All that is awful, but the far greater sin is happening in the depiction of business profits in the earnings reports. In its simple form, profit is revenue less expenses. However, the arguments around cash versus non-cash costs, and onetime versus ongoing costs give every management team a lot of leeway in how profits are shown to investors.
Let's look at a financial metric called EBITDA (Earnings Before Interest Tax Depreciation and Amortization). EBITDA has become the most common metric to judge business profitability. However, there are serious flaws to this metric. Management is calculating the profits without the depreciation and amortization costs because they are non-cash. Yet, a lot of these costs are real. Most of the companies incur regular expenses to maintain the competitiveness and unit volume of their product or service. Those expenses are incurred first but flow into the income statement in later years in the form of depreciation. Thus, depreciation is considered a non-cash expense. Nonetheless, it was real cash dollars that went out of the business when the capital expenditure was incurred. It is just being recorded now because of accounting rules.
The bad use of EBITDA doesn't stop there. The companies are adjusting this incorrect profitability metric: examples include "Adjusted EBITDA" and "Operating EBITDA". In most cases, the companies are removing stock-based compensation or items like pension costs.
When a company lays out capital to maintain its existing business revenue and market share, it is an ongoing business expense. And if those costs shouldn't be accounted for in the company's profitability, where do they belong?
Another example of deception is Free cash flow calculation, and this is a growing area of inaccurate representation. I guess this is because most investors love this metric and it is overused. I see a lot of companies show this metric without removing the stock-based compensation. Writing this feels ironic to me (showing free cash flow to investors without a true expense). However, management and investors don't believe it. The degree of this misrepresentation is so high among a certain set of companies that free cash flow is either negligible or negative after adjusting for this real expense.
Again, when a company is paying somebody (stock-based compensation) that means less money for investors. And if those costs shouldn't be accounted for in the company's free cash flow, where do they belong?
One of the key qualitative tenets in an investment is the magnitude and degree of management trust. Thus, the companies should take more steps than required by any kind of accounting rules to earn shareholder’s trust. Some CEOs have taken steps towards this goal by not running their business based on some analyst estimates. Brian Moynihan, Chief Executive Officer of Bank of America, sets a good example here, and I applaud his words during the recent earnings call (emphasis is mine).
<Analyst Question>Yes. Basically, the FICC trading results in the fourth quarter on a historical basis were very strong. But they did miss analyst estimates, not just at BofA, but at JPMorgan, at City at Goldman, everybody. And what I'm trying to understand, is there something in the environment that's changing, that's making it more difficult [indiscernible] too aggressive in their expectations?<Brian Moynihan>That, I don't develop those expectations. But our team had a good year and Jimmy and the team drove the business well. They do it consistent with how we run the franchise, keeping the balance sheet -- 1/3 of the balance sheet in the $30-odd billion of capital we have in the Markets business. And for the year, we earned above -- well above our cost of capital, and they did it -- think about the environments almost by month that were shaped. So we feel good about it.And so I'll let Lee follow you offline to some of the broader questions, but we don't set other people's estimates, we only set our own.
In the current environment of easy money and easy trading (more retail investors), winning the hearts and minds of shareholders is easy for companies with incorrect representation. However, companies should discard such behavior. The companies should take steps to move away from showing metrics that dwarf the true profitability and should focus on excellent business execution rather than forecasting the future. The company's focus shouldn't be around false representation but around building true shareholder trust.
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