A few decades back, a substantial portion of the value of a corporate was believed to be embodied in its book value resulting in a (share) price to book value or PBV multiple closer to one. But, things have changed since then. Today, it is the opposite that is widely believed. For a vast majority of industry sectors, only a smaller portion of the value of a corporate is reflected in the book value, leading to PBV multiples greater than one. For example, a corporate with a PBV multiple of five has only 20% of its value reflected in the books and 80% is outside. A PBV multiple of less than one on the other hand may reflect any one of three possible scenarios, namely the corporate is truly undervalued, assets are overvalued or investors have a poor perception of its earnings and future potential. The data presented in YCharts demonstrates how PBVs of corporates have been moving over the past several decades.
PBV multiples as at March 31, 2017 of the various sectors into which corporates listed on the Colombo Stock Exchange have been categorised, were as follows:
|Banking & Finance||1.00||1.47||0.61|
|Chemicals & Pharmaceuticals||0.77||0.82||0.70|
|Hotels & Travels||0.92||2.52||0.35|
|Beverage, Food & Tobacco||4.09||46.81||0.40|
|Construction & Engineering||1.04||1.30||0.55|
|Power & Energy||0.89||1.33||0.72|
Source : Daily Report of John Keells Stock Brokers (Pvt.) Ltd. for Friday, March 31, 2017
For example, investors have valued players in the Banking and Finance Sector exactly at book value on average, with the highest being a PBV multiple of 1.47 times and the lowest being 0.61 times. However, a player in the Beverage, Food & Tobacco sector commanded a PBV multiple of 46.81 while at the lower end, a plantation company was worth only 0.26 times the book value.
To make things worse, today, certain megatrends such as digitalisation, exponential technologies, unorthodox competition, increasing concerns on sustainability, demographic changes etc. are shaping the future at a phenomenal pace. These will undeniably challenge the conventional business models, making past financial performance less relevant for any assurance about the future potential of a corporate. These changes are altering the complexion of the investors too.
The importance of understanding the customer need not be overemphasised for a corporate to be sustainably successful. Given the changing information needs, it is as important for corporates to have a clear understanding of the investor. It is this understanding that provides the context within which corporate reporting needs to be structured in general and the annual reports in particular. In fact, provision of relevant information is a sine qua non to effective investor engagement.
In the circumstances, corporates need to recognise changes that are taking place with regard to the information requirements of investors, if investors are their primary target audience for the annual reports. [Going by the contents of the annual reports of some countries, awards organisers rather than investors appear to be the primary target audience for some corporates]. Investors are increasingly becoming interested in the future potential of a corporate than its past performance and non-financial information is getting more and more relevant for ascertaining the future potential. Anyway, it is all about sustainable value creation for all the stakeholders. Unless and until the information content is aligned to these changing needs, annual reports are of little use to the investors.
Corporates need to understand as to what explains the significant differences in PBV multiples across industries and across corporates within the same industry. In a case of a PBV multiple of five, to what do investors attribute the 80% of the value outside the books? Similarly, if it is less than one, what are the reasons for the market to value it at less than the book value and who is to blame? Is there anything that corporates can do to enhance PBV?
Among others, the main factors that drive the value of a corporate include:
- Corporate strategies
- Resources (tangible and intangible capitals) available
- Business model
- Differentiating factors
- Profitability and financial position
- Growth prospects and opportunities
- Understanding the evolving landscape and readiness to face challenges
- Risk, governance and compliance
It is up to the corporates to identify those drivers of value, strategise and execute them on one hand and communicate them to the investors on the other. [The latest incident involving United Airlines reminds us of the growing dominance of social media which has enabled every stakeholder to have a voice in today’s corporate world]. The annual report is certainly an effective medium of corporate communication.
Leaving all kinds of errors and omissions aside, due to statutory and regulatory requirements, various corporate publications – interim financials, annual reports, investor presentations, webinars, press releases etc. contain extensive disclosures on financial value creation in a historical perspective. Annual reports in particular have detailed information in this regard although accounting standards and reporting formats have made it double Dutch to many readers.
Unfortunately, information pertaining to a corporate’s potential to create value in the future has fallen appallingly short of investor expectations.
While constructing lengthy chapters on their commitment to sustainable value creation, corporates also need to undertake a candid evaluation of their annual reports to determine whether their reports communicate to the investor information needs. Are their claims material to the investor and can these claims be substantiated? Or do they gloss over their responsibility to communicate truthfully through a riot of colours and a surfeit of words presented in encyclopaedic thickness? Generally, investors are cautious about the degree of candour in information outside the financial statements.
Let us come back to the investors’ interest in the future potential and the role of non-financial information in this regard. It is up to the corporates and in their own interest to identify the kind of information that needs to be disclosed in the annual report. While it can vary across industries and even among players in the same industry, shareholders would have been delighted to hear that the Company had five years’ revenue in hand in confirmed orders as shown in the following disclosure in the Boeing Company Annual Report 2015.
(Extracted from Financial Highlights on page 1. Contractual backlog represents contracted orders for which funding has been received while total backlog includes contractual backlog and unobligated backlog, which represents contracted orders for which funding has not yet been authorized and appropriated.)
So, the question still remains as to how a corporate can demonstrate its future potential and what kind of non-financial information needs to be presented to achieve it. I would suggest the disclosure of the following information for each stakeholder (together with details as to how a corporate is managing its Governance, Risk and Compliance) may be a simple and straightforward approach in this regard.
- A detailed analysis of the stakeholder (supported with statistics that reflect the trend, say, for the past five years). For example, a tabulation of growth in customer base which has doubled over the past five years may assure the investors that the customer acquisition strategy has been working.
- Various initiatives taken to deliver value to the stakeholder (in the year under review as well as in the recent past). For example, a financial institution kept open for customers till 8.00 pm daily and over the weekend may be providing enhanced convenience to the customer.
- The impact of those initiatives referred to in 2 above (preferably quantified as much as possible). For example, an improvement in customer satisfaction ratio from 60% to 80% over the past five years may reflect that the corporate has been delivering on its customer promise.
- Various initiatives planned to be undertaken in the short to medium term (ideally stemming from the strategic plan)
Given the kind of information and communication technology available, information that can be generated under each of the above is limited only by imagination and the will to disclose.
The above information can be presented in such a way that it demonstrates the corporate strategies, resources available, business model, differentiating factors, growth prospects and opportunities and an understanding of the evolving landscape and readiness to face challenges.
However, certain obstacles appear to prevent corporates from disclosing information relevant to the investors. Some of them include:
- Compliance mindset with statutory requirements and voluntary guidelines
- Fear of incurring proprietary costs, helping competition and hurting company’s prospects
- Obsession for winning awards
- Lack of candour with only positives being detailed
- Fear of making forward looking statements
Corporates should weigh the above obstacles against the following incentives to disclose what investors need.
- Demonstrating high standards of corporate accountability
- Building trust among the investor community
- Avoiding ‘short terminism’ among investors
- Building a loyal base of investors with a long term view of the enterprise
- Opportunity to make the annual report a marketing tool
- Avoiding the risk of investors assuming the worst
- Lowering the cost of capital
- Overall positive impact on the PBV
Although there may be some contention that disclosure of strategies for inorganic growth is detrimental to a corporate, that argument is unlikely to hold water for organic growth.
The obstacle of being reluctant to disclose strategies can to some extent be overcome by demonstrating the success of the strategies adopted through a detailed analysis of each stakeholder, various initiatives undertaken to deliver value to them and the impact of those initiatives as identified above. Another option is to convert the information into some form of an index if the disclosure of absolute numbers is believed to be damaging.
Times have changed, but not all corporates with it. Instead, they have opted to believe that they are rightly valued!
A Chartered Accountant and the Chief Officer Process Development at Smart Media The Annual Report Company