UK: WHO NEEDS EARNINGS? - As a measure of company performance, earnings per share held sway for over 20 years. But as its many shortcomings are increasingly - and cruelly - exposed, cash flow analysis is gaining ground.

by Richard Thomson.
Last Updated: 31 Aug 2010

As a measure of company performance, earnings per share held sway for over 20 years. But as its many shortcomings are increasingly - and cruelly - exposed, cash flow analysis is gaining ground.

There was a time when it seemed easy to assess the performance of a company. You simply looked at its earnings per share (eps) which, if you were a shareholder, told you how much money your capital was making. How very comforting to have such a simple way to measure performance, how easy to compare one company with another, how convenient to see the company's value relative to the market.

Except that now many people are not so sure. Indeed a large part of the investment community is turning its back on good old earnings per share, claiming that it is neither simple nor convenient - nor even truthful. You can tell something pretty radical is taking place when the head of the Accounting Standards Board (ASB) himself, David Tweedie, pronounces: 'Anyone who still uses earnings per share needs his head examined.' The fact that eps has held sway for over 20 years gave it an authority which few people seriously questioned until a few years ago.

Then came the 1980s boom, with companies growing faster than ever before. To keep growth going and the profits flowing, more and more companies became increasingly creative with their accounting. There were mutterings of disquiet in the investment community, but it was not until the recession that the full horror of what had been going on in the name of earnings per share was revealed.

The names of Coloroll, Polly Peck and Maxwell Communications are indelibly stamped on the minds of investors who had happily followed the eps measure and thought their money was in good hands. After the dust of these spectacular collapses had settled, questions began to be asked. How is it, after all, that Polly Peck had managed to report profits of £161million (70% earnings growth) only days before it went bust? Why had nobody pointed out that the company had been haemorrhaging cash for a long time which had eventually swept away its value? The accountants looked embarrassed; the analysts made feeble excuses. Clearly something was horribly wrong with the way companies were being valued.

With eps knocked from its pedestal, people suddenly began to find all kinds of things wrong with it. The method for calculating earnings was, after all, simply an accounting convention and the conventions differ from country to country. In an increasingly international investment world, this was not much help.

Take Daimler Benz, for example. In 1993, the big German car manufacturer decided to register its shares on the New York stock exchange. It was therefore required to submit its accounts calculated under US rather than German accounting rules so that US investors could understand them. But investors found to their astonishment that while Daimler was hugely profitable under German rules, it was actually making a loss under US rules. So whose rules were right? Was Daimler profit-or loss-making? If the answer was 'both', what use were these profit figures anyway?

Another problem with the traditional earnings figure was that it was purely historical. It told you nothing about where the company was going. It took no account of future growth or expected inflation. Nor did it give investors any information about the market risk faced by a company. It was, said its detractors, not so much simple as simplistic.

Even worse, earnings have proved all too easy to manipulate. Admittedly the Accounting Standards Board under Tweedie has taken great strides in reducing the excesses of the past, particularly on the treatment of extraordinary items and taking provisions on acquisitions. But with areas such as acquisition accounting, depreciation rates and provisioning still part of the make-up of reported earnings, eps remains a dubious lead indicator of corpo-rate performance.

The problem, of course, is what measure to use instead. As so often in investment analysis, the pioneering work seems to be coming from the US where there is an increasing emphasis on cash flow. As any private company owner will tell you, a company is of little use to its shareholders unless it has the capacity to produce cash. The beauty of cash flow, say its supporters, is that you cannot hide it. It is like air in a balloon - you know if it is going in or coming out, and it is easy to see the effect it has on the balloon itself.

While part of cash-flow analysis focuses on the current cash flow, picking out the cash from the non-cash items, the real value is in assessing the long-term cash flow that the company is likely to generate. This is not straightforward. As might be expected, there is a bewildering range of different methods of measuring and analysing company cash flow.

One approach, devised by a US professor Frank Rappaport, involves calculating a company's cash flow up to 10 years in the future and discounting it back to the pre-sent to get the net current value of a company to its shareholders.

Another system is Economic Value Added (EVA), developed by Joel Stern in the US. This involves calculating the cost of a company's equity. This must be higher than simple, low-risk deposit or gilts rates to make it worth an investor's while taking on the extra risk of investing in the company. The extra return to investors - that is, the cost of equity - reflects the risk attached to the company by the stock market (the so-called 'beta factor'). The cost of debt, if there is any, also needs to be factored into the calculation. Once the overall cost of capital has been established, it can be measured against the free cash flows generated by the company. The surplus of cash over cost of capital is the additional wealth created by the company. A shortfall shows that the value of the company is actually being eroded. Many company managements like this approach because it enables them to calculate whether they have added value year by year, whereas the Rappaport system is not so precise.

The merit of either process and their many variations is that they focus on present and future cash flows rather than past earnings. The more uncertain the future cash flows of a company, for example, the more speculative are the company's shares. To reach a present valuation of the company, the value of future cash flows has to be discounted back to the present. The more speculative those cash flows look, the more heavily they are discounted. So it is not surprising that recent studies show that there is a far closer correlation between the company share price and cash flow than between the share price and earnings. A company's share price should in theory reflect its ability to generate a cash surplus above its cost of capital. Those companies which produce less cash than their cost of capital should see their shares trade at the most lowly levels.

The switch from eps to cash flow measures of performance is not happening over night. There is a kind of push-me-pull-you process happening in Britain between investors, brokers and companies. Large institutional fund managers are firmly in the vanguard, gently urging company managements to accept this form of analysis. Groups such as the Prudential have already developed highly sophisticated computer programmes to aid their calculations. Some stockbrokers, such as Warburgs, James Capel and BZW, have made a feature of cash flow in their analyses of companies after noticing that their investment clients were increasingly demanding this, but not all have grasped the significance of cash flow yet. Smaller houses, and those catering mainly to private investors, probably have neither the resources nor the incentive to indulge in the complexities of cash flow analysis.

While many companies may regularly use cash flow as a way of assessing new investment projects, many still see it as an inappropriate measure for assessing their overall performance. 'Eps isn't a particularly good measure, but it's better than anything else,' says Tony Habgood, chief executive of Bunzl. 'We are measured on whether we are at a premium to our sector of the stock market, and that requires an eps. The problem with cash flow is that you cannot use it to compare one company with another easily. Eps gives an easily identifiable measure to everyone.'

Nevertheless, management consultants are waging an intensive campaign to persuade company managements to focus more on cash flow. Price Waterhouse, for example, has developed a sophisticated model based on the EVA method to show managers how they should be able to improve their share price by adjusting a range of variables such as capital investment, cost of capital and sales growth.

Those closest to the financial markets are wary of the overuse of analysis but accept that cash flow is a better tool than eps. Warburgs has embraced cash flow more wholeheartedly than most, particularly in analysing European companies. Its particular method - Enterprise Value - is similar to EVA but concentrates on the core operations of the company. The cost of capital is calcu-lated only after the estimated market value of anything considered to be a peripheral asset, including some subsidiaries, has been stripped out. 'You still have to make intelligent judgments about how a company uses its cash flow,' says Nick Stevenson, head of European equity strategy. 'But that is better than trying to make judgments about how accountants will play with a company's earn-ings figure.'

Mark Tinker, head of UK equity strategy at James Capel, emphasises that people can become too obsessed with cash flow, earnings or dividends and forget about the importance of share price. The market, after all, does not always work like a mathematical formula. A market which fully and accurately reflected companies' future performance would see very little share price movement. In reality, share prices almost always overshoot and undershoot their true value and it is the broker's task to know when this is happening. And when investors attempt to value a company according to its prospects over the next 10 or 15 years, trends tend to take over from calculations.

'The market rating of a company is determined by the medium-term growth and risk profile,' notes Tinker. 'When you are pricing this, it matters relatively little whether you look at earnings or cash flow.' Tinker is also aware that many of his clients are still very uncomfortable with cash flow analysis. 'You have to talk to investors in a language everyone understands. That is why it often comes back to talking about earnings.'

It was, however, the larger and more sophisticated institutional investors who started to abandon the eps cult earliest, particularly as they watched the corporate disasters of the early 1990s and the failure of earnings per share to warn of the dangers. 'Cash flow is a purer measure of company performance than earnings,' says Dick Barfield, head of investment at Standard Life. It forms part of his analysts' normal procedure in examining a company. But although it may be the most important measure, it is never the only one. 'We've always looked at a broad range. There is no one measure that will tell all you need to know about a company,' says Barfield. He also looks at earnings, gearing and a list of other ratios that all tell slightly different stories.

Different measures work better for different companies. For most straightforward companies, Barfield believes, earnings per share is still a pretty reasonable guide. In a complex conglomerate, however, where the accounting becomes extremely confusing, cash flow will almost certainly be a more reliable measure, while the eps should be treated with extreme caution.

If cash flow becomes a more generally accepted method of analysis, what will the effects be? Most changes are likely to be beneficial. It will, of course, become extremely hard for managements to play the old accounting games to boost earnings without a solid underlying performance to support it. The old 1980s tricks will cease.

At the same time, managements will start to take a longer term view of their businesses. Where share prices slavishly reflect earnings figures as they are reported, there is continuous temptation for managements to focus on short-term measures. If the markets reflect long-term ability to generate cash, slumps or volatility in short-term earnings will be overlooked where the long-term prospects remained intact.

This requires an equal sophistication among investors. A company embarking on a capital investment programme will have to explain to shareholders that although this means a drop in short-term cash flow, it will enhance cash generation in the long term.

A few years ago, this might have fallen on deaf ears. These days, investors tend to welcome this approach as evidence of strategic thinking by the company. There is also likely to be a completely different approach to takeovers. In the 1980s, the rationale was usually to add a new earn-ings stream, to move into a new market, to achieve cost-saving synergies, or simple empire building. Many people have wondered at the real value of many of these deals: a look at the cash flow effect shows that about half of all acquisitions add no value at all to the buyer. Using acquisitions to boost eps would die away if cash flow was the focus of attention.

The 1980s' technique of acquiring companies, making provisions and then filtering the provisions back into the earnings figures would be firmly stamped out. The Indian Rope Trick of enhancing eps by acquiring businesses on lower price/earnings ratios than that of the acquirer would also be seen through. An analysis of the cash flow effects would show simply whether or not the deal added any value for the shareholders.The supporters of cash flow claim that it also makes company managers think more like shareholders because it concentrates their attention on the actual value of the company. They are forced to decide, for instance, whether they can reinvest the capital the company generates at a level that adds value. If they cannot, they are likely either to give it back to shareholders in the form of dividends, or buy back the company's shares which can be expected to raise the value of those still in circulation.

Few people claim that looking at cash flow is the cure for all ills. It can, for example, become extremely complex and is probably way out of the reach of ordinary investors. But a large chunk of the institutional investment community now uses it as a matter of course, and an increasing number of company managements are beginning to see a real value in looking at their businesses this way.

There is a clear incentive for them to do so. A cash flow analysis is only as good as the information on which it is based and companies refusing to supply the information investors want may find themselves increasingly penalised. 'The danger is that we may get a two-tier system of companies that accept cash flow analysis and those that don't,' says Gareth Williams, manager of corporate finance at Price Waterhouse. Those that do will provide the stock market with the copious amounts of information needed to construct adequate cash flow projections. But the companies that continue to resist cash flow as a measure of success will also resist giving out more information than absolutely necessary, and their share prices are likely to suffer.

No one expects earnings per share or price/earnings ratios to vanish completely, but their weaknesses are now well recognised. In an entity as complex as a commercial company, no single measure of performance will ever be adequate to give a complete picture. Cash flow, however, may soon become the one people care about most.

HEADLINE EARNINGS - ABS puts the emphasis on maximum disclosure.

'Headline earnings' is the key profit figure used by commentators whendiscussing a company's profits.After applying a standard tax charge, headline earnings are divided by the number of shares in issue to produce an earnings-per-share figure. The eps figure can then be divided into a company's share price to give a price/earnings ratio, such as that published in the Financial Times share price pages.

While this appears to be straightforward, there has been considerable discussion as to what should be included in the headline earnings. In the past, companies were given considerable flexibility as to what constituted extraordinary items (excluded from the headline earnings calculation) and exceptional items (included). This meant that reported earnings could be very different from cash profits being generated within the business.

To reduce the degree of discretion left to companies, so that shareholders had a clearer idea of underlying performance, the Accounting Standards Board (ASB) insisted that all extraordinary items and exceptional items should be included in the profit figure produced in a company's Report and Accounts.Companies can split out these figures in their accounts but the overall presentation, particularly for previous years, must now show profits incorporating exceptional and extraordinary items.

In contrast, most companies and analysts (and the FT) broadly follow the method advocated by the Institute for Investment Management and Research. This excludes most extraordinary and exceptional items - any gain or loss, in fact, which cannot be counted as part of the company's normal trading activities. The idea is that the eps figure should reflect a company's basic trading performance.The ASB has sanctioned this method but decided that, for formal reporting, leaving exceptional and extraordinary items in the earnings figure fitted best with their declared aim of maximum disclosure in company accounts.

CASH FLOW - Past performance and future value.

There are two elements in focusing on cash flow. The first is to use it instead of profit as the expression of historic performance. This requires delicate discrimination between items such as investment in new projects and investment in replacement equipment. The table (right) shows the most widely accepted method of calculating free cash flow.

The second use is to attempt a valuation of a company based on its future cash flow. The ability to construct such a model depends on the quality and range of information available. An analyst would need the annual accounts, the chairman's statement and to have the company's estimates of future turnover, growth rates and margins, tax rates, and cost of borrowings. Looking at the past two years' profit and loss accounts gives an idea of how this will be turned into cash. The information which is available from most companies allows a reasonable assessment for up to four or five years, but the analysis has to look 10 or even 15 years ahead to be most useful. For this, the analyst uses data about the sector and market conditions in which the company operates, and extrapolates cash flows from that.

The Calculation

Turnover 100 EBITDA* 25

Actual tax paid (5)

Operating cash flow 20

Working cap. invested (4)

Fixed cap. invested (2)

Free cash flow to reward debt &

equity investors 14

* Earnings before interest, tax, depreciation, amortisation.

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