To appreciate value, we have to look beyond earnings

by David Holland
Rising profits do not necessarily reflect good strategic decision-making, or the creation of long-term economic value. That only occurs when companies invest in positive net present value (NPV) strategies where the return on capital exceeds its cost. Every student of finance is taught this rule.

This should be essential to any valuation, yet it is often forgotten. Many management teams, for instance, are incentivised to grow profits. The trouble is that managers focussed only on earnings will do all they can to grow those earnings, and this 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. Recent examples include Woolworths’ purchase of Australian retailer David Jones and Famous Brands purchase of Gourmet Burger Kitchen in the UK.

Steinhoff too had an insatiable hunger for acquisitions and opaque financial structures to match. While these activities may have seemingly increased its accounting earnings, they resulted in negative free cash flows and destroyed shareholder value.

The company's buyout of Mattress Firm in the USA is an example. It was apparent at the time that Steinhoff was paying a high premium when one considered the combination of growth and return on capital that were implied in the price it paid. Investors should have been asking why a company would pay that much for a mattress seller in a market where so much retail is going online.

An oft-stated rationale for these acquisitions is to diversify risk on behalf of shareholders, but that is a mistake. Shareholders can diversify for themselves far more cheaply and efficiently by buying shares directly in the company of their choice, without having to pay a legion of investment bankers and lawyers to seal the deal (never mind the additional remuneration to executives for managing a larger business).

Asking the right questions about the allocation of capital

When analysing a company or questioning its executives, it is important to discern whether earnings growth is coming from higher leverage, increasing investment, or operating efficiency. More debt means more risk. Investments should only be made when the expected net present value is positive. Improving operating efficiency is the toughest task but where managers must shine. This comes from improving operating margins and increasing asset turns. All forms of earnings growth are not the same.

Naspers is another company where questions of capital discipline are relevant. The market is clearly expressing a view about its allocation of capital as it is trading at a massive discount to the market value of its holding in Tencent. This implies that the market is expecting management to destroy value by continuing to invest more capital in negative net present value projects. Every rand invested is expected to return less than a rand in present value: the exact opposite of Warren Buffett’s advice on capital allocation.

If you take Tencent out of Naspers' financial statements, and look only at the core operations on the company's balance sheet (the assets that Naspers’ management actually controls), the return on those assets has been declining for the past six years and sits well below the cost of capital. Naspers might do itself and its shareholders a favour by returning capital instead of investing more of it. The first law of holes in finance and life is to stop digging when you are in one.

Focus on economic profit and sustainable competitive advantage

Strategy and finance should be joined at the hip when formulating a company’s plans. The purpose of a firm isn’t to maximise short-term earnings but rather to build a sustainable competitive advantage. In doing so, it is more likely to invest in positive net present value strategies, which might hurt earnings in the short-term. Amazon’s net income has been meagre for decades only because accounting standards classify R&D as an expense, not an investment. Amazon Web Services (AWS), one of its most profitable businesses, would not exist if Jeff Bezos, the CEO of Amazon, had focussed on earnings management instead of investing in future value creation.

Instead of EBITDA (Earnings before interest, taxes, depreciation, and amortization), operating profit, or earnings growth, managers should be incentivised to increase economic profit. Although this might sound like a subtlety, 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 shareholders equity, which is not free. Economic profit aligns the income statement (earnings growth) with the balance sheet (capital discipline). Mondi is an example of a company in a highly competitive industry that enforces capital discipline at all levels of the organisation.

What this shows is that when valuing an enterprise, it should be based on long-term expectations. Markets are not, as many people believe, inherently short-term in nature. If anything, markets are taking short-term views on long-term outcomes.

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. Clicks is a world-class company that generates an impressive and stable return on capital which attracts local and foreign investors. Its price to book ratio of 14 indicates that investors are already paying for a healthy stream of future cash flows and positive net present value investments. Critically, there is a lot more to ensuring these long-term expectations are delivered than just finding ways to maximise earnings.

If a company fails to train its staff properly, treats its customers poorly, or flouts regulations it will lose business and hurt future cash flow. While this would certainly be bad for shareholders, it would also affect their employees, customers and all other stakeholders. Think of the impact that the collapse of African Bank had on its staff, clients, creditors, investors, regulators and the wider financial services industry. It is clearly in everyone's best interests to have companies that think long term and manage long term. Parastatals are not immune. They must also display capital discipline by generating competitive returns on capital.

In other words, sustainable practices and business models are an imperative. 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.

David Holland is an adjunct professor at the UCT Graduate School of Business and teaches on the MBA Programme’s Company Valuations Course. He is the author of the new book ‘Beyond Earnings’.

Useful resources:
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.
University of Cape Town Graduate School of Business, Executive Education
Executive Education at the UCT Graduate School of Business is dedicated to growing the leadership backbone in organisations and individuals and inspiring a new generation of leaders to engage with the challenges of the African continent in a hyper-connected and globalised world.
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