Accounting standard s, Joe Blow investor and the death of the PE ratio

By Shoeshine

Friday 27th August 2004

Along with a slightly dubious profit result, Sky City Entertainment this week announced it would be reporting its December first half using international financial reporting standards (IFRS), one of the first New Zealand listed companies to do so.

By January 2007, everyone will be using IFRS. Screeds have been written about the Herculean effort companies are going to have to make to meet the deadlines, with, of course, their trusty beancounting advisors constantly by their side.

Less attention has been paid to the coming revolution in investor communications.

For listed companies, for the sharebroking and investment advisory community, for company valuers and even for the media, the change will throw up a big challenge and it's one some market observers are already worrying about.

"There is a big issue for the mum and dad investors because they're going to see earnings going all over the place," says Paul Hocking, executive director of Infinz, the institute of finance professionals.

The intentions behind developing IFRS and pushing for countries to adopt them are to enhance transparency and the comparability of companies' financial reporting across borders. Most observers feel the effort is likely to be successful.

The problem is the changes will fundamentally affect indicators earnings per share, PE ratios and other earnings multiples that smaller investors, company valuers and the media have used for decades.

For New Zealand companies, the main culprits are changes to the accounting treatment of goodwill, intangible assets and financial instruments.

Of these, probably the best recognised and understood is goodwill, which has the virtue of being easy to explain.

Under the current standard, goodwill a somewhat vague concept roughly approximating the difference between what a company pays for something and the tangible assets acquired is held on the balance sheet and amortised.

That is, it's reduced by a set amount each year. Reported profits are reduced by the amount of each year's amortisation.

Freightways, by way of example, took a $4.9 million charge for goodwill amortisation through its profit and loss account last year.

Under IFRS 3, goodwill will no longer have to be amortised.

Had Freightways reported this year under IFRS, it would have been able to add $4.9 million to its reported profit, jacking it up 31% to $20.6 million.

The flip side of this is that the goodwill on Freightways' balance sheet will be subjected to an annual "impairment test." That means that, should the earnings of one of the companies Freightways bought take a dive, its valuation on the balance sheet would have to be written down, resulting in a one-off charge to reported profit.

Bogeyman number two is IAS 38, an international accounting standard governing intangible assets that is, "an identifiable non-monetary asset without physical substance."

This has been one of the bloodiest battlegrounds of the IFRS revolution; in Australia, it's reckoned $30-40 billion will be wiped off company balance sheets.

That's because companies will no longer be allowed to carry on their balance sheets any value for brands that are "internally generated" that is, brands they've built up themselves, and not bought from somebody else.

This is arguably the change Joe Blow investor is going to have the most trouble getting his head around. Even accountants are starting to find this stuff hard to understand.

The change is something of a problem for Lion Nathan and Fairfax but not for Freightways. The trucker has $87.4 million of brands on its balance sheet, but they were all paid for and so will, under IFRS, be subject to the same impairment test as its goodwill number.

Culprit number three is IAS 32, which deals with financial instruments. But Shoeshine, in consultation with his spirit medium, feels readers' attention might be starting to flag a little here.

The point of all this is that the time-honoured bottom line, net profit after tax, has been under attack as a meaningful indicator of companies' performance and wellbeing for many years and IFRS may deliver a fatal blow.

The increased volatility of net profit will undermine the price-to-earnings (PE) ratio, a time-honoured way of comparing the share price level of companies in similar industries.

Earnings will be affected even up to the ebitda (earnings before interest, tax, depreciation and amortisation) line, so the earnings multiples comparison used by independent appraisers of takeover offers, for instance, will also be undermined.

What will be used instead?

Analysts generally value companies by discounting future free cashflows, but that's hardly a method available to Mr Blow.

Even so, it's possible that in newspaper share tables a measure such as the ratio of enterprise value to free cash flow could replace the PE.

Another question is, who's going to explain all this to Mr Blow?

Sharebrokers don't see it as their problem. They'll educate their own clients; why should they bother about anybody else's? The New Zealand Exchange doesn't appear to have thought about it yet.

In the absence of any lead from the securities industry it looks as if companies themselves are going to have to do the explaining. Look for a surge of demand in the investor relations market.

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