I have demonstrated in previous posts on this blog, mainly based on the evidence in The End of Accounting… (Wiley 2016), that corporate reported earnings are now largely irrelevant to investors. GAAP earnings no longer move markets: I have shown (with Feng Gu) that even if you could predict all the companies that will meet or beat analysts’ consensus estimates, or the companies that will miss the consensus, and invest, or sell short, these companies’ shares three months prior to the earnings release, your gains will be minimal (1.5-2.0%), similar to those of “momentum investing” (investing in previous winners). But many investors and analysts, still clinging to the old valuation models taught in business schools, are skeptical. Earnings should still be the linchpin of securities analysis and valuation models, they believe. That’s the reason they keep pestering managers for earnings guidance.
A recent front page article in the Wall Street Journal (“Wall Street to CEOs: Disrupt Your Industry, or Else” 5/26/17) supports my earnings irrelevance claim: “Investors and boards long obsessed with quarterly profits are now hunting for leaders to make big, fast bets to fend off upstarts shooting for the moon. Ford Motor Co.’s recent decision to boot then-Chief Executive Mark Fields, a 28-year veteran of the company, exemplified a shift in the priorities of big companies across the U.S. The message is simple: In an age of rapid disruption by the software and tech industries, a leader has to pick up the tempo and make riskier bets sooner…or else…. It does mean established companies need to consider drastic measures. They must be willing to tell their stakeholders they may have to lose money … while scaling up new technologies and methods.… Mr. Fields [Ford] was returning consistent profits…. [But] The share price is down 40%… Amazon made almost no profit for its first 20 years.”
I fully agree with the Journal, except for the statement: “[Companies] must be willing to tell their stakeholders they may have to lose money… while scaling up new technologies and methods.” They will “lose money” only by the dated and largely irrelevant GAAP (or IASB) definition of earnings. In realistic terms, these companies won’t lose money. The reason: the expenditures required to “scale up new technologies and methods”—R&D, IT, employee training, etc.—while expensed by GAAP, causing low, and often negative earnings, aren’t really expenses. They are investments generating future benefits. So, there is no need to tell investors “they may have to lose money,” while the company scales up new technologies, rather, there is an urgent need to devise a new meaningful corporate performance measure, replacing the antiquated accounting earnings. Here is such a performance measure:
Adjusted cash flows
- Start with “Cash from Operations,” reported in firms’ cash flow statement. I prefer cash flows over earnings, because earnings are derived from numerous subjective managerial estimates (bad debts and warranties reserve, for example), many of which are unreliable and sometimes manipulated (asset and goodwill impairments). Cash flows are largely factual.
- I then add to cash from operations the intangible investments (R&D, IT, customer acquisition costs) which were expensed in the income statement. These investments are cash outflows, but they are not expenses. They are expected to generate future revenues (from new products and services), and hence should not be subtracted from a performance measure. This adjustment prevents my measure from showing losses when the company “scales up technologies and methods.”
- I then subtract a three-to-five-year average of annual capital expenditures (property, plant & equipment), to compensate for the elimination of depreciation in the cash flow computation. This adjustment is also performed in the widely-used “free cash flow” measure.
- Finally, I subtract a charge for the company’s equity capital ($64 billion for Cisco in July 2016), invested in the company. This is a bona fide financial expense ignored by accountants.
The end-result of this computation is my preferred performance measure: Adjusted Cash Flow.
For comparison, Sirius’ reported (GAAP) net income was $207 million and $173 million for the first quarters of 2017 and 2016, respectively.
Finally, is the proposed adjusted cash flow measure an improvement over GAAP earnings or cash from operations? Indeed, it is an improvement. To demonstrate this, I computed (with Feng Gu) investors’ returns from a perfect prediction of the three measures. Specifically, we computed how much would an investors have earned during 2009-2014, if he/she could predict for each industry the five firms with the highest annual “adjusted cash flows” (along with the highest earnings and cash from operations), and the five companies with the lowest measures. Then, based on these predictions, you invest at the beginning of the year (roughly 12 months before earnings announcements) in the high earners, and sell short the shares of the low earners. Your returns from these investments are the gains to investors from predicting each of the three performance measures.
As the figure below (for firms with R&D) makes clear, in each of the years 2009-2014 (expect for 2012), and for the six years combined, the proposed adjusted cash flow measure (left, blue bar for each year) beats the other two contenders in generating investors’ returns. (This measure and test are fully explained in chapter 18 of The End of Accounting.)
So, here you have an empirically-proven, easy to compute enterprise performance measure, superior to GAAP (or IASB) measures. Returning to the Wall Street Journal article in the opening, with this measure you won’t have to ask shareholders for patience while you report “losses” because you won’t report losses as long as you are truly investing in innovation.
(Please note: I am soon leaving for a European lecture tour, so I won’t have new postings for three weeks.)