How to interpret company results
Allan Gray picks companies to invest in after careful scrutiny of audited company results, presentations and annual reports. Information from this process is used to help determine the fair value of a share for potential investment. But keep in mind that
every six months companies report a host of numbers to the market, using different metrics to support these figures. Profit or earnings per share (EPS) is most common, and is widely used to calculate the priceto-earnings ratio (P/E), earnings yield and dividend pay-out ratio. But variations are often used by listed companies, described as either “normalised”, “adjusted”, “headline”, “continuing”, “diluted”, “attributable” or “comparable normalised headline” EPS.
“The issue comes in when a company reports multiple and different EPS numbers, creating confusion, and in some cases, overly inflated figures,” explains Leonard Krüger, portfolio manager at Allan Gray.
He says that management teams argue that the prescriptive international and South African accounting standards used to report on a company’s financial situation often don’t reflect the reality of their businesses, resulting in EPS variations. But in a number of cases management compensation is based on adjusted EPS, providing a powerful incentive to ensure that the figure reported is as high as possible.
“While some adjustments are valid, companies on average tend to present a far more favourable EPS number than that dictated by accounting rules. This gap between reported EPS and the adjusted EPS can often be substantial, averaging 15% in recent US company reports,” says Krüger.
He explains this by using the example of PPC, the South African cement maker, which completed a discounted recapitalisation of its business in September this year. Since 2012, its normalised EPS earnings have always been higher than its EPS, except for at the end of March 2016, when it reported a slightly higher EPS. He says that an investor who only focused on PPC’s normalised EPS would have noticed a business with declining profits but may nevertheless have been comforted by what still seemed like a solidly profitable enterprise reporting in excess of 140c/share of profit as recently as March 2016. “The hypothetical investor would have failed to recognise the substantial negative free cash flow per share PPC had been incurring since 2014 and the deteriorating balance sheet and liquidity position of the company.” But, he says that some industries are justified in using EPS variations or other indicators, and they can be used positively. Life insurance companies, for example, try to aid investor understanding by publishing an Embedded Value (EV) statement every six months, which is an estimated fair value on its current policies. The typical insurer writes new policies daily, policies it expects Portfolio manager at Allan Gray to make money from in the future. EV places no value on the ability of the insurer to write these new policies. “If an insurer has a track record of a conservatively stated EV, there is a good reason for it to trade at a premium to published EV numbers.”
Krüger’s message to investors is to view reported and adjusted published numbers with a fair dose of scepticism, especially as the average investor is often unaware or ignorant of these upward biases.
“If the difference between reported and adjusted numbers is large or increasing, history suggests that additional caution is warranted. Look beyond the metrics the market focuses on and don’t rely on a sole metric: an investor focused on only one metric might fail to identify risks and/or opportunities.”
In addition, he suggests that investors attempt to understand why company managers or investors are focusing on the metric being presented and the implications of this. However, there is no doubt that this process can be complicated and can take an extraordinary amount of time.
“If you have an investment manager that does this for you, make sure that you understand their approach to navigating the nuances and pitfalls on your behalf. After all, you will be the one to ultimately gain the return,” concludes Krüger.
“While some adjustments are valid, companies on average tend to present a far more favourable EPS number than that dictated by accounting rules.”