Executives need to embrace transparency if they want to help investors make investment decisions. But what should be disclosed?
January 2009 • Robert N. Palter and Werner Rehm
As the credit crisis sorts itself out, one outcome investors and regulators will almost certainly demand is more transparency into the strategy and the underlying operating and financial performance of companies—not only the financial ones at the storm’s center but all companies. Managers should enthusiastically embrace such reforms.
In our ongoing research into investor communications, we’ve concluded that companies should provide more detail about how their businesses create value, give an honest assessment of performance, and provide guidance on the most important operating metrics that illuminate what underpins value creation in the medium to long term. Too often, managers are cowed by fears that a more detailed discussion of the issues and opportunities facing a company would reveal sensitive information to competitors, generate too much work for the investor relations department, or create excessive pressure to report too many numbers or to meet unrealistic performance expectations. As a result, managers typically provide only the data required by generally accepted accounting principles—leaving the more detailed and specific performance and value contributions of the business’s various pieces hidden from investors, who are left to wonder what the company is hiding.
More transparency would benefit all investors but should prove particularly attractive to those seeking to build a deep understanding of a company’s strategy, current performance, and potential to create long-term value. The better informed these intrinsic investors are about the true value of a business, the more likely the share price will reflect an alignment between market value and intrinsic value.
Our discussions with investors and our own experience in helping companies estimate value suggest at least three ways for them to be more forthcoming.
More detail
Disclosure limited to the data required by securities regulators and accounting procedures may give executives considerable leeway to interpret the rules. But more important, such limited disclosure often obscures the metrics investors need most to make informed investment decisions. For example, both international financial reporting standards (IFRS) and US generally accepted accounting principles (GAAP) require a company to disclose sales, a profitability metric, depreciation and amortization, capital expenditures, and some balance sheet items for each significant business segment. However, this information does not always allow investors to assess value across business units with very different economics—such as widely different operating leverage or working-capital intensity.
One large global electronics company, for example, in a section of its 10-K, reports gross margins by geographic segment as a metric of segment profitability. In another section, it reports sales and gross margins of both product and service businesses. Nowhere does it provide operating margins for various products targeting business and consumer markets—information that is crucial to help investors value businesses with different intensity of R&D and of selling, general, and administrative costs (SG&A). A failure to report such information often leaves investors with the impression that management does not understand what really drives value or is trying to obscure some underlying performance issues. In another case, a US media conglomerate provides detailed income-statement information by business unit, but the schedules leave it to the investor to sort out the balance sheet by business units as different as movie production (which capitalizes costs) and traditional paper publication (which does not).
How much detail is enough? In the case of financial data, it depends on whether the information is critical to assess value creation. IBM discloses constant currency growth below the business unit level. Nestlé does so on a product and regional level. This kind of detailed financial information is very helpful to investors and doesn’t give competitors any insight that they wouldn’t already have into business models or sources of strategic advantage. As a rule of thumb, to determine the optimal level of disclosure, companies should provide a detailed income statement, down at least to the earnings before interest and taxes (EBIT) level, for each business unit. They should also provide all operating items in the balance sheet (if not a full balance sheet), reconciled with the consolidated reported numbers required by securities regulators and accounting procedures. Even companies in a single line of business can improve their disclosure without giving away strategically sensitive information. Whole Foods Market, a US grocery chain, provides a return-on-capital metric by age of store. This gives investors deeper insights into the economic lifecycle of different businesses and assets, as well as the trajectory the company expects for economic profit under different growth assumptions.
On the operating side, what to disclose depends on the key value drivers of a business or business units. Ideally, these should be the metrics management uses to make strategic or operational decisions. Each quarter, the IT research firm Gartner Group, for example, discloses a narrow but detailed set of metrics for each of its three business units. As Gartner’s CFO explains, the firm publishes only the most important of the metrics that management uses to examine the performance of the business. Companies in some industries, such as steel and airlines, likewise regularly disclose volumes and average prices, as well as the use and cost of energy—the key drivers of profitability.
Thanks to technology, some companies can make such disclosures almost continuously. Continental Airlines, for example, prominently displays a daily updated load factor, one of the key drivers of value, on its investor relations Web page (one click away from the home page). Some may wonder if such frequent updates are really very useful, but there is no doubt companies can use technology to improve the way they communicate the value drivers that matter most to investors. Executives should ask whether a company discloses enough for an investor to obtain a clear picture of its performance. Such information helps intrinsic investors make informed buy and sell decisions—the foundation of what investor relations should be trying to accomplish.
A common mistake among companies disclosing operating data is to provide different metrics from quarter to quarter, depending on which of them reflects best on the company. One quarter the preferred metric may be unit sales, in the next it could be revenue growth, and in the next growth in Asia. This approach probably hurts more than it helps, because consistency matters. Investors rightly wonder why management has stopped providing the figures for any given metric and, in all likelihood, assume the figures are worse now than they were when the company published them. Instead, a company should change the metrics it reports only when the key drivers of its current growth performance change. In such cases, the company may add to the metrics or substitute one for another, but only if it offers a candid explanation.
In the current environment, transparency is more important than ever and more highly valued by investors. Take the case of Berkshire Hathaway, which had to take accounting losses on some derivative positions in recent months. These losses were determined by a model used internally to assess the value of the positions. The actual method for the valuation was not transparent to investors, and it was unclear whether Berkshire Hathaway had to post collateral against these positions. Only after public discussion and a promise to disclose (in the next annual report) “all aspects of valuation,” including “deficiencies in the formula” for pricing derivatives, did investors calm down.
