MBA.co.za Home

An MBA OverviewChoosing the right MBAApplying for your MBAMBA School DirectoryMBA PerspectivesMBA ResourcesMBA News & EventsMBA Summit

NEWS
502 Henley Africa students graduate in 2018
502 Henley Africa students graduate in 2018

Does your leadership style contribute to employee wellbeing?
Does your leadership style contribute to employee wellbeing?

Helping SA companies to get serious about innovation
Helping SA companies to get serious about innovation

Let the scales fall from our eyes so we can see clearly
Let the scales fall from our eyes so we can see clearly

UNISA SBL honours Dr Judy Dlamini and Mr Thomas Kgokolo
UNISA SBL honours Dr Judy Dlamini and Mr Thomas Kgokolo

Can a younger generation breathe new life into SA activism?
Can a younger generation breathe new life into SA activism?

MPC decision to raise interest rates sends negative signal
MPC decision to raise interest rates sends negative signal

New law will give the Auditor-General the
New law will give the Auditor-General the "right to act"

Pravin Gordhan receives honorary doctorate from Henley
Pravin Gordhan receives honorary doctorate from Henley

Embrace failure if you want to succeed
Embrace failure if you want to succeed

10 traits that make for a good small business leader
10 traits that make for a good small business leader

Pay, power and politics: Where did Carlos Ghosn go wrong?
Pay, power and politics: Where did Carlos Ghosn go wrong?

How many days of this year have you lived?
How many days of this year have you lived?

Imagining the futures of South Africa in Africa
Imagining the futures of South Africa in Africa

What drives great entrepreneurs?
What drives great entrepreneurs?

The entrepreneur’s journey: Lessons from along the way
The entrepreneur’s journey: Lessons from along the way

Is war between China and the US inevitable?
Is war between China and the US inevitable?

How SMEs can bolster growth in future-oriented industries
How SMEs can bolster growth in future-oriented industries

Mandatory ESG provisions could be a game changer
Mandatory ESG provisions could be a game changer

Mini-budget - the implications for business
Mini-budget - the implications for business

GIBS EMBA moves up 20 places on UK Financial Times ranking
GIBS EMBA moves up 20 places on UK Financial Times ranking

Meaningful professional development demands a shift in focus
Meaningful professional development demands a shift in focus

Has the water crisis made SA business more resilient?
Has the water crisis made SA business more resilient?

Medium term budget shows that SA's economy remains weak
Medium term budget shows that SA's economy remains weak

SA’s education needs to adapt to digitalisation
SA’s education needs to adapt to digitalisation

To appreciate value, we have to look beyond earnings
To appreciate value, we have to look beyond earnings

The role of the corporation needs a fundamental reevaluation
The role of the corporation needs a fundamental reevaluation

How we can all resist state capture
How we can all resist state capture

SA’s energy future a pawn in a larger political game
SA’s energy future a pawn in a larger political game

Rationalising corruption: Did the devil make you do it?
Rationalising corruption: Did the devil make you do it?

GE’s leadership problem goes beyond its CEO
GE’s leadership problem goes beyond its CEO

South Africa’s jobs summit failed to tackle the hard issues
South Africa’s jobs summit failed to tackle the hard issues

The real story behind Uber’s exit from Southeast Asia
The real story behind Uber’s exit from Southeast Asia

New MBA timetable starts in 2016
New MBA timetable starts in 2016




06 NOVEMBER 2018
To appreciate value, we have to look beyond earnings
Every student of finance is taught that rising profits do not necessarily reflect good strategic decision-making, or the creation of long-term economic value. That only happens when companies invest in strategies where the return on capital exceeds its cost. So says David Holland, adjunct professor at the UCT Graduate School of Business who teaches Company Valuation on the MBA programme.

Writing in his new book, Beyond Earnings, co-authored with Bryant A Matthews, Holland argues that strategy and finance should be joined at the hip in company planning. “The purpose of a firm isn’t to maximise short-term earnings, but rather to build a sustainable competitive advantage,” he says.

Sometimes this might mean investing in long-term strategies that could hurt earnings in the short-term.

“For example, Amazon’s net income has been meagre for decades only because accounting standards classify R&D as an expense, not an investment,” Holland says. “Amazon Web Services, one of its most profitable businesses, would not exist if CEO Jeff Bezos had focussed on earnings management instead of investing in future value creation.”

Unfortunately, many management teams are given incentives to grow accounting profits, which is relatively easy to do. They can buy back shares, take on risky levels of debt, and invest in projects that generate earnings but destroy value, such as acquisitions made at steep premiums.

“The financial press is littered with reports of write-downs and problems digesting foreign acquisitions,” Holland notes. “Recent examples are Woolworths’ purchase of Australian retailer David Jones, and Famous Brands' buyout of Gourmet Burger Kitchen in the UK.”

Steinhoff too had an insatiable hunger for takeovers. While these activities may have increased its accounting earnings, they resulted in negative free cash flows and destroyed shareholder value.

Asking the right questions about the allocation of capital

Instead of earnings, operating profit, or earnings growth, managers should be incentivised to increase economic profit. Although this might sound like a subtlety, Holland shows it is not. Economic profit is what is left after the cost of capital has been taken into account.

“The biggest issue with an income statement is that there is no charge on shareholder's equity, which is not free,” Holland argues. “Economic profit aligns the income statement, which shows earnings growth, with the balance sheet, showing capital discipline.”

Valuing an enterprise this way is based on long-term expectations.

“If you look at the valuations of many successful companies, they are priced to maintain a high return on capital for a long time into the future,” Holland says. “Clicks is a world-class company that generates an impressive and stable return on capital which attracts local and foreign investors. There is a lot more to ensuring that the long-term expectations of these investors are met than just finding ways to maximise earnings.”

For instance, if the company fails to train its staff properly, treats its customers poorly, or flouts regulations, it will lose business. While this would certainly be bad for shareholders, it would also affect employees, customers and all other stakeholders. It is therefore clearly in everyone's best interests to have companies that think long-term and manage long-term.

“In other words, sustainable practices and business models are an imperative,” Holland says, adding that he was inspired to write the book to help investors, financial professionals, and students to improve their ability to value a company.

“When evaluating a company, you have to ask whether its board and management team really understand how to create economic value over the long-term. Have they put in place the necessary succession planning, corporate culture, key performance indicators and innovative environment to sustain it? Because if they haven't and if they are focused only on short-term earnings management, then you shouldn't want any part of it unless you are a speculator.”

Beyond Earnings is available at www.amazon.com and www.takealot.com or google book
Source:

University of Cape Town Graduate School of Business
UCT GSB is internationally renowned as one of a few business schools in Africa with the prestigious triple-crown accreditation with endorsements from EQUIS, AACSB and AMBA. As a top school with more than five decades of experience in Africa and other emerging markets, UCT GSB has a responsibility to engage with its socio-political and economic context. Its teaching, learning and research are directed towards addressing the complex and pressing economic and social challenges of our world today. Visit our InfoCentre or website.

Share: Facebook
Facebook Twitter
Twitter LinkedIn
LinkedIn Email
Email
Share
Other Print
Print Newsletter
Newsletter


About MBA.co.zaMBA NewsletterTerms of UseContact Us