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

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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.”

Leonard Krüger

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