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
or google book