Imagine you were able to accurately predict a company’s earnings statement ahead of time,’ says professor Feng Gu, co-author (with professor Baruch Lev) of The End of Accounting and the Path Forward for Investors and Managers. ‘How much money could you make if you knew ahead which company would beat, meet or miss its consensus forecast?’ In theory, it would allow you to consistently beat the markets – at least according to investor orthodoxy.
Ever since Benjamin Graham, mentor to Warren Buffett, outlined his stock-picking methodology in Security Analysis, looking at and predicting corporate earnings has been a staple of equity investing. To work out the health of a company, investors and analysts dig into its numbers and data to anticipate quarterly or annual results before they are announced. The intention is to gain an edge over investors who have not been doing their homework. However, Gu and Lev argue that the hypothetical predictive machine would not be worth much anymore, as reports are no longer a good way of measuring whether a company looks strong or weak.
According to their research, the average gains from investing in US companies that will meet or beat their consensus estimates have fallen dramatically over the past 30 years, in turn reducing the usefulness of earnings reports. From 1989 to 1991, the average gains from identifying companies that should meet or beat consensus earnings estimates were 6 per cent a year. This figure dropped to 2 per cent between 2013 and 2015.
‘It used to be that earnings reflected real revenues, costs and expenses,’ says Lev. ‘Earnings really reflected the performance of companies.’ However, changes in the economy and business environment over the past 30 years have meant that their usefulness as a measure of a company’s health has diminished. ‘Over time,’ says Gu, ‘accounting relevance has declined.’ Driving this change, they argue, is the rise in the importance of ‘intangible assets.’
The intangible economy
Unlike tangible assets such as machine equipment and buildings, intangible assets don’t have physical embodiment. They can include company ideas, tech knowledge, patents, and research and development (R&D). Gu explains that, like tangible assets, intangibles are ‘valuable because they require investment to generate returns over long periods’.
Over the past 30 to 40 years, intangible assets have become increasingly important for businesses, driven by both technological changes and globalisation. Investment in traditional, tangible assets dropped from 15 per cent of gross added value in 1977 to 9 per cent in 2014, representing a 40 per cent drop. Meanwhile, intangible assets investments increased from 9 per cent of added value to 14 per cent over the same period. Technology focused companies are among the clearest examples of this, but most businesses invest more in intangibles than ever before.
However, Gu and Lev contend that despite such changes, accounting regulators have not caught up, diminishing the utility of earnings statements in assessing a company’s health. Tangible assets are ‘capitalised’ on accounts, meaning their recognition as expenditure is delayed, but intangible assets are often not treated in the same way. A company’s investment in intangibles such as brands, software or R&D is often still treated as an immediate expense on its accounts. This means they are charged against earnings – despite the fact that intangible assets are more likely to be the value-creating component of the company.
New approaches to value
Non-accounting metrics, says Lev, often give better insight into the value of a company’s strategic assets. ‘When it comes to media businesses, internet services companies and similar firms, look at how many subscriptions were added this quarter,’ he suggests. ‘Likewise, look at the user churn rate – those defecting from the service.’ Also key is customer acquisition costs: if the amount spent acquiring each customer is increasing, that’s a bad sign; a decrease in acquisition per customer is a good sign.
When it comes to biotech and pharma, there are other key determinants to consider. Take into account the product pipeline, says Lev: ‘Look at where in the development stage their products are. Have the products reached clinical trials? How are they progressing through trial stages?’
However, looking at other measurements of intangible assets is fraught with risks. Spending on R&D is not a guarantor of future value creation – the research could amount to nothing. Gu points out that a company’s investments in intangibles are inherently higher-risk, and that if investment in intangible assets fails to produce results, there is little chance that the firm will recoup any costs, in contrast to tangibles. ‘That is something investors should always keep in mind.’
There is also the risk that the company in question will never even see its product come to market. In this context, the old-fashioned method of scrutinising accounts is still very useful. For instance, says Paul Mumford of Cavendish, when it comes to investing in biotech firms, simply looking at the company’s trial stage progress is not enough.
‘If you are looking at biotech and pharma, it is wise to delve down into profit and loss accounts, cash flow and balance sheets,’ says Mumford. ‘The problem is the potential for them to run out of cash. Even if they pass their stage three trial – and therefore are ready to be made publicly available – these things often take longer than anticipated and firms can often be fairly stretched. Be aware of the fact that the company could run out of money.’
Investors should look at the ‘cash burn’ – the rate at which a firm is losing money, says Mumford. ‘What I have found with biotech companies in the past,’ he says, ‘is that they tend to be a little over-optimistic. Regulators take longer than anticipated to approve drugs. It becomes a much more tricky game.’ Looking at the cash burn, therefore, should give investors a better idea of whether or not the company in question will have the money to cover itself until the product comes to market.
Ultimately, says Julian Chillingworth, chief investment officer at Rathbones, ‘cash is most important in this sort of discussion’. When you invest in a company, you hope it can produce some sort of return in the future. ‘Follow the cash,’ says Chillingworth. ‘Is this company producing positive cash flow? Is there any left to pay you a return afterward?’
How balance sheets don’t tell the full story
There are many examples of how the health and potential of a company looks when its balance sheet is considered in isolation. Lev gives the example of Tesla – once described as a ‘cash-¬ ow incinerator’. ‘Look at Tesla and its balance sheet,’ he says. ‘It has around £4 billion of accumulated losses. It loses close to £1 billion a year.’ In part, this is because much of its investments appear as expenses on its balance sheet. Yet it has a market value of $50 to $60 billion. This is because of investors’ belief in the brand and in research and development (R&D) – the rm’s strategic assets. It is those intangible assets that investors consider as a guide to the company’s future value, not quarterly revenues.
Amazon is a similar example. ‘For years, it has reported losses,’ says Lev. ‘In the last four to five years, it missed half its consensus earnings.’ However, notes Gu, ‘Amazon has strategic resources – particularly its brand name.’
Another example is pharmaceutical rm Kite Pharma. This company, says Lev, ‘is at the forefront of cancer research. However, if you looked at its income statement last year, you would see that it has losses worth several hundred million dollars because of research and development expenses’. Yet to look at this firm’s income statement alone would risk understating its worth. At least its buyer thought so – in 2017, Gilead Sciences acquired Kite Pharma for $12 billion.
For companies such as Kite Pharma, the value created comes not from traditional tangible assets, but from intangible assets such as R&D and patents. Its ‘strategic assets’ are not its laboratories or the buildings which house them, but the research carried out and the intellectual property created. However, according to income statements, its value creating strategic assets incur huge losses, while its tangible – and often less important – assets will be capitalised, and costs can, therefore, be spread across accounts over a much longer period of time.
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