Are annual reports (EPS)
useful to calculate shareholder value?
Are financial reports useful to determine corporate value?
Although the relevance
of traditional financial reports and Earnings per
Share (EPS) are heavily criticized, as of today they still remain the
most widely used method of communicating the historic performance of
companies.
One cannot use
historic performance as any guarantee of future returns. This simple fact
already renders annual reports useless as far as estimating future value
creation is concerned.
Additionally there
are several more reasons why
earnings (accounting profit)
fail to reliably measure the economic value of firms. They are:
1. Alternative accounting methods may be employed (both required changes by FASB or IAS and voluntary changes can change reported earnings, but do not
affect economic value),
2. Risk is excluded (both business risk and financial risk are not accounted
for in annual reports),
3. Investment requirements are excluded (changes in for example the
working
capital are not considered in reported earnings),
4. Dividend policy is not considered (for example dividend decreases will
show increased reported earnings but are in fact value neutral),
5. The time value of money is ignored (no present value calculation in
reported earnings).
Over the last 10 years,
an additional 6th major reason has appeared:
6. The increased role
intangibles play in our economic system, which has moved from an industrial
economy towards a services and knowledge oriented economy.
Although intangible
assets have been around since the dawn of civilization, due to certain
factors, including increased competition (globalization, deregulation) and
the advent of information technology (notably the internet), the structures
of corporations were changed.
This combination of
factors catapulted the relative significance of intangible assets in the
eighties and nineties of the 20th century compared to their tangible peers
into the major value drivers of business in our modern economy:
- In 1978, 5% of all assets were intangible
- In 1998, 72% of all assets were intangible
- Currently, 75-85% of all assets are intangible
So the cause of decreasing significance of accounting for value
determination is not an attempt to mislead investors, market makers,
managers or governmental agencies by accountants.
Intangibles are
generally still not regarded as assets in traditional accounting systems.
The
consequences of above described
shortcomings of annual reports on Value Creation are severe.
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