This is a guest post by Mr Ashwini Damani – by education he is CA & CFA and fundamental investor. Do follow him on twitter https://twitter.com/ashwinidamani he has written very nice piece on India Cement Industry (he has worked in cement industry) in past and shared there and lot of other stuff.
Event Notes of Mind the GAAP – Business Analysis in a World of Outdated Accounting Standards by Prof. Sanjay Bakshi
While accounting and financial reporting appear to be constantly changing to keep up with the times, you will be surprised to learn that the fundamental structure of corporate reporting to shareholders – Balance Sheets, Income Statement and Cash Flow Statement, as well as their specific line items – is in fact, frozen in time, having stagnated over the past 110 years.
It was against this backdrop that Prof. Sanjay Bakshi conducted his session on how to do Business Analysis in a world where Accounting Standards have failed to keep up to date with the ever evolving world.
The Problem with Reported Earnings
The problem with reported earnings is that don’t follow the realities of the business. Instead they follow an arcane process.
The World today is changing and new forms of businesses such as the likes of Uber, Facebook, Airbnb etc dominate the valuation scenarios – these companies have no assets on which we can value them – yet they dominate the valuation tables.
How to Deal with Reported Earnings –
Warren Buffet has long been a votary of the fact that Reported Earnings should be adjusted to arrive at Owner Earnings, he claims that Owner Earnings represent – Reported Earnings PLUS Depreciation, Depletion, Amortization, and certain other Non Cash charges LESS The average annual amount of capitalized expenditures for plant and equipment etc that the business requires to fully maintain its long term competitive position and its unit volume (c).
Buffet argues that often analysts don’t adjust for (c) and hence end up overpaying for companies – There are multiple types of cases when, (c) needs to be adjusted
When a Company has to constantly reinvest in Capital Expenditure just to maintain its competitive position
Prof Bakshi cited the example of Samtel Colours – a maker of CRT Television – Samtel used to earn Accounting profits every year it was in operation, but whatever cash it generated from operation had to be always reinvested capital expenditure in maintaining the same position (same volume, profit and market share), in the ever changing technological world of television industry. It had to keep modernizing the plant and machinery to ensure that it could produce televisions which were required as per new technological changes. In the end, it never had any Owner Earnings – So even though it was earning accounting profits – it never made cash on a net basis due to the constant reinvestment needs. Thus any analyst who valued the company on reported profits, ended up overpaying for the company, because there came a time when Samtel could no longer reinvest and ended up winding down.
When a company has put more money in Incremental Working Capital just to maintain its competitive position
Prof Bakshi cited the case of an FMCG player which had to increase its Debtors Days from 30 days to 50 days just to ensure that its competitor did not win over the Distributors by offering better trade terms. In this case the distributor had to bear additional Working Capital of Rs. 100 Crores just to match the trade terms set by the competitor.
Though the Accounting Profits adjusted for the Interest Portion on this increased working capital requirement- but that did not reflect the reality that this Rs. 100 Crores of Principal itself should have been adjusted from the value of the entire company – because this is the amount which will have to be locked in just to maintain (and not grow) the market position. This is a permanent impact on the value of the company, until new scenarios emerge.
When a Company invests money in making the Moat Stronger – Don’t get fixated on near term earnings
This is a case where (C) has to be added back and not reduced. There are often cases, where a company spends money to make its mat stronger by spending money on advertisement or distribution channel in a way that it drives out competition and increases the market share and strength of the company. In these cases, the accounting world often treats these outflows as an expense, when in reality it should be treated as an asset because it increases the future earning capacity of the company.
Some such examples are :
Free Samples – An FMCG company uses Free Sample to boost its future sales. One out of every 8 pieces of Sanitary Pads it sells is given free of cost to the prospective customer (a young girl in school). The FMCG company has observed that these free samples help it win the trust of the young girl and in turn makes them a lifelong customer. Thus even though Accounting treats this as Sales done at Zero Cost and thus lowers the Gross Margins of the company, in reality this expense is an asset which helps the company over a much longer term.
- Aggressive Pricing – Company cuts its product prices in order to impact competitors – In this case the strategy of the company is to bleed out the competitors. The accounting world treats this by lowering Sales Value, when in fact it creates an asset.
- Delayed Gratification – Using Profit of one entity to fund losses of another entity –Normally such a decision is considered as Capital Mis-Allocation, but sometimes this could be a strategy of the company to create a trend for Customer Spending. For example a company might be running a State of the Art Showroom at loss, but this showroom could be infact creating a habit culture for its product of a different vertical, and thus making it earn profits elsewhere. So these losses should rather be treated as an asset and not expense. A classic example could be of Amazon, which earns profits from various other means, while it often burns cash to create a better customer experience.
A Business Analyst has to be adaptive enough to identify and distinguish assets from expenses and actual Profits from reported profits. He has to stop being uni-directional and focus on what the company is trying to achieve. He has to analyse what are the consequences if things go right and what are the consequences if things go wrong.
Accordingly each accounting line item has to be then dealt and treated in a way separate from what the GAAP buckets it into.
By Ashwini Damani – https://twitter.com/ashwinidamani