Thursday, December 17, 2009

XBRL – Part Three, or, Son of the Return of XBRL

Back in January and February of this year, I wrote a couple of pieces about how I didn’t really get what all the whoopla surrounding XBRL was about. Those pieces generated a fair amount of comments and I even wound up talking to the folks at the SEC about XBRL. Not to put too fine a point on it, at the time I stated that I just couldn’t understand how XBRL was going to revolutionize the use of data by investors.

While I was doing research the other day on the SEC’s EDGAR database of filings, I noticed that reports are now beginning to be tagged as having “Interactive Data”. So I thought that I owed it to myself to go back and see how this XBRL stuff works in practice. Maybe the scales would fall from my eyes and I would see the error of my ways. Maybe I would be able to see how the data flowed seamlessly, enabling us to quickly reach investment decisions that were lost to us before. And maybe pigs would fly.

What I found when I went to the interactive data was that you could click on a heading such as Income Statement, and the P&L would come right up. I found the data had two properties: first, the headings were tagged. So for example, if you click on Revenues, you find that it’s US GAAP, the data type is monetary, the balance type is a credit and the period is the duration of the quarter. In other words, what you learn in Accounting 101. Secondly, you can grab the data and paste it into another document fairly easily. Also of note was the fact that the financials and notes are available as an Excel download, although everything I downloaded had a file name of “Financial_Report.xls”, so if you don’t rename the file right away, it becomes one of many with the same name.

After I had played with the data for a while, I sat back and thought about the cost /benefit analysis for what we’ve gone through with XBRL. On the benefit side we’ve gained a bit of functionality. I, for one, will welcome the ability to grab data off a downloaded spreadsheet rather than re-keying it when I want to do some analysis. But I don’t see a lot beyond that. The tagging of the data seems to merely tell me what I knew before. Further, professional investors have had the data in comparable and downloadable form for years. Systems such as Bloomberg and Telemet Orion (and I assume Reuters, although I have no experience with that system) already perform this function and a lot of other analytics as well. So my conclusion is that only relatively small investors are being helped. Against this we have to weigh the thousands of dollars spent and numerous man-hours invested by every company converting to XBRL.

To me this seems like another example of something that sounds good in theory, but the practical advantages just don’t seem to live up to the hype. In other words, it’s a governmental agency imposing a standard where the costs outweigh the benefits. The irony of it all is that the ultimate cost for all of this will be born by investors, because the cost of adopting to the new systems is a corporate expense, which lowers earnings, which will result in lower share prices.

Friday, December 4, 2009

A Discounted Cash Flow View of Investor Relations

Every now and again, it’s helpful to stop and think about the frameworks in which investor relations operates. From a finance viewpoint, traditional academic finance approaches the valuation of a company along the following lines: “the value of a company is based upon investors’ estimates of the sum of its future cash flows, discounted back to their present value”. (Investors will often use earnings per share and dividends per share as proxies for cash flows.) The confidence that investors have in those estimates is based largely upon: 1. A company’s past performance as a measure of its ability to continue to perform, and 2. The investors’ view of the economy and the markets as expressed by the discount rate they assign to the cash flows. In other words, what drives the equation are estimates about the future, using the past record of the company as a reality check.

When you think about it this way, several interesting things about investor relations pop up. First, the equation is predicated on what will happen in the future, yet most of investor relations is spent explaining what occurred in the past, i.e. last quarter. So it’s important that proactive investor relations officers spend much of their time discussing what the firm is doing to insure future revenues and where the markets for their products are headed. If investor relations can’t, or won’t, explain how the firm intends to grow revenues, earnings and cash flows into the future, they shouldn’t expect investors to make that leap of faith for them. Companies that have to sell products or services will almost always have better forward-looking market data than investors. Judiciously sharing that data with investors will help them make better estimates. And by removing some uncertainties, it can help lower the discount rate assigned to the cash flows, which results in a higher present value.

Secondly, management matters. How can investors be expected to place large bets on your company’s future performance through the ownership of stock, if they haven’t met and assessed management’s ability to continue to perform? Yet many investor relations departments view their roles as gatekeepers, only allowing access to management at limited times to favored investors. If you want to achieve fair valuation over the long haul, investors need to speak periodically with management. Investor relations departments can function to save management a lot of time by making sure investors understand the company before seeing management and by covering what I would characterize as “routine maintenance” questions, but eventually, investors need to hear directly from the management team to see if they have a grasp on strategy, details, customers and markets.

Third, consistent profitability over the life of the investment will be more valuable than big profits in the out years of the investment, because they will be discounted less and will help compound earnings projections in later years. Consistency will also help investors assign lower discount rates to future cash flows, as they are much more comfortable projecting based on visible trends than they are if your earnings are all over the map.

So why then does everyone make such a fuss about the most recent results, and why do the short-term results seem to have such an outsized influence on the stock price? The answer, quite simply, is “Because that’s the way the math works”. (When my kids were struggling with math in grammar school I used to tell them that all of life was a math problem – this is a perfect example.) If, based on recent results, an analyst reduces their estimate for the first year of a five year model, not only does the reduction count for more because it is almost entirely undiscounted, but it will reduce estimates in future years, as the models are constructed to build and compound on previous years. Further, if the model is taking dividends into account by estimating them as a percentage of earnings, it will reduce all subsequent dividends as well. Conversely, changes made to estimates in the later years of a model have a much smaller effect on estimated present value and the price investors will pay for a company’s stock.

To put all of this in perspective, smart investors are betting on your future success, and that’s where the bulk of investor relations communication should be. But don’t neglect to adequately explain current earnings because if you don’t, and estimates are too low in the early years of investors’ earnings models, the perceived value of your firm will wind up being too low.

In other words, the ability to adequately explain current and past performance creates the foundation necessary for investors to understand a company, but helping them understand the basis for future profitability is the structure they need for estimating a fair value for your stock.