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Commentary
Fighting EBITDA
So what has happened to accounting over the last 20 years? Actually, GAAP is now delivering much better financial statements than it did – but are people using them better?
The best way to think about financial statements is always to ground them in investment theory. If we are trying to understand the economic performance of a company the question of value creation is fundamental so the starting point is to measure the return the company is earning on investors’ capital, then compare that to the cost of capital. Measuring return on capital brings intellectual coherence to reading financial statements – it forces us to think about the integrity of the accounting data, and it counters our preoccupation with income by bringing the balance sheet centre stage.
For financial statements to provide the data integrity of a properly conducted investment appraisal we need income to be comprehensive and the balance sheet to give a complete account of the assets and liabilities of the firm. And we would need those assets and liabilities to be measured at their opportunity cost to the investor – call this current value.
US GAAP and IFRS have both made a lot of progress on the first two. Companies now clearly account for their comprehensive income, and the balance sheet is much more complete than it was. The final step will be to capitalize operating leases.
Then GAAP will probably have gone as far as it is going. GAAP has a fundamental bias towards conservatism, and thus towards understating equity. So balance sheets will continue to omit home-grown intangibles and continue to prefer historical cost for recording assets, and income statements will seek to anticipate costs and postpone the recognition of gains. My own view is that we can easily live with GAAP‘s conservatism as long as we understand it.
What about the users? 20 years ago was the heyday of the ‘shareholder value’ movement, and return on capital thinking was naturally at the centre of that. The consulting firms already had big value management practices and spent a lot of time developing proprietary metrics like EVA and CFROI, and thinking about the integrity of the accounting numbers that went into them. In the investor world, both the buy side and the sell side started to use these tools, to give them a competitive edge and because value investing anyhow demands a return on capital approach.
Unfortunately, Enron had unforeseen consequences for analyst practice, at least on the sell side. Enron perfectly demonstrated the need for good fundamental analysis. But the reforms that Eliot Spitzer and others pushed through in the aftermath eventually had the effect of stripping a lot of resource out of the sell side so that, now, there are observably less analysts publishing fundamental research.
In parallel, there appears to be a loss of focus on the rigorous measurement of income and of return on capital. This is nowhere so evident as in the cult of EBITDA.
EBITDA’s popularity grew in the late nineties when, coincidentally, there were many loss-making technology businesses trading on the market at sky high valuations. Because EBITDA always gave a more cheery number than EBIT or earnings, it provided a useful basis for valuation multiples.
EBITDA is part of the story – used with care it can be a useful in isolating the relationship between revenues and a certain subset of costs. However, and worryingly, EBITDA has become the story for many companies, analysts and commentators. EBITDA makes unprofitable businesses look profitable and, moreover, is very vulnerable to creative accounting. Because EBITDA ignores depreciation, as well as interest, taxes and amortization, so it is not in any sense a measure of income. Because EBITDA ignores working capital and capex – in other words ignores the balance sheet – it is not a measure of cash flow. As Warren Buffett put it: Does management think the tooth fairy pays for capital expenditures?
So while I do believe that financial statements have got better over the last 20 years, it is not so clear that people are using them better. That is a continuing battle!
Chris Higson, March 2015
What to do about foreign takeovers
The UK has always held a wide open door to foreign takeovers. UK takeover policy is laissez-faire and decisions about takeovers are believed to be for the shareholders alone. When the UK was one of the biggest beasts in global acquisitions the open-door philosophy suited it. However the tide has sharply reversed and since 2004 the inflow of acquisition capital to the UK has significantly exceeded the outflow.
As a result, whenever a big foreign takeover is in the air there is an anxious debate about whether government should be intervening. We had this when Kraft was acquired by Cadbury and, a couple of years ago when Pfizer bid for AstraZeneca. Recently, in the general election hustings, Prime Minister David Cameron made a surprise announcement that he would block any future attempt to take over BP, the British oil major so financially damaged by Macondo. The next morning, in a perfect expression of shareholder value zealotry, the Financial Times said, BP shareholders have paid for the right to determine the company’s future. The government has not. It is Mr Cameron, rather than Jonny Foreigner, who should hop it.
In my paper What to do about foreign takeovers I examine the arguments. I start by challenging this very British belief in the primacy of shareholder value. It is the job of government to protect the national self-interest and that public interest is largely about creating and maintaining high wage employment and protecting and nurturing the intangible assets that sustain it. In the modern world where nations are competing against each other for the capital of mobile, rent-seeking transnational businesses there is no reason at all to expect maximising shareholder value by corporations to coincide with the self-interest of the UK or of any other individual nation.
The concern about foreign takeovers is about ‘home bias’ – the belief that companies have a dominant national allegiance, so that replacing domestic ownership by foreign ownership must reduce domestic investment and employment in the long run. Home bias is a factor in this discussion, but the reality is much more complex. Observably, many of the U.K.’s most successful industries, including the resurgent automotive industry and the dominant financial services industry, are overwhelmingly foreign-owned, frequently as a result of takeover.
This is the reason you cannot generalise about foreign takeovers. What we want is good owners, and it doesn’t much matter whether they are foreign or domestic. Good owners take a long-term view and have a commitment to developing domestic employment and to nurture and build the intangible asset base. Tata Motors has turned out to be a good owner – since its acquisition in 2005, it has turned Jaguar Land Rover into one of the world’s top performing car companies. The Indian owner appreciated the value of the intangibles it had acquired – the skills, the know-how, the brands. It brought in senior management from BMW and a willingness to make very large financial investments in training and physical plant in the UK. Equally, the concern around the Cadbury and AstraZeneca bids was that Kraft and Pfizer were not viewed as good owners in this sense.
Without doubt the priority of the government is to focus on maintaining the nation’s competitive advantage – those features that make a country an attractive place for mobile international capital to invest, and where the best managerial talent will want to work. But government may need to be willing and able to intervene in foreign takeovers, and the UK is now almost unique in its unwillingness to do this. The quality of ownership has to be assessed on a case-by-case basis, and this is what government should be looking at. Government needs to have the tools to measure the public interest when required, and I explain what those tools look like in the paper.
Chris Higson, March 2015
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