With recent market rallies in U.S. stocks taking many indexes to all time highs, the popular press has witnessed an increasing number of articles questioning whether this “bull run” just might be nearing its end. One such article by Tomi Kilgore titled “Analysts Chart Stocks’ Voyage to the Unknown” reviews the use of technical analysis in predicting future stock prices and trends. Another piece by Larry Swedro titled “Is a Stock Market Bubble Brewing?” discusses the Shiller P/E 10 ratio which is based on inflation-adjusted earnings. What really got my attention in this article was that the reported Shiller P/E 10 ratio is now more than 40 percent higher than its historical average. And according to the Wall Street Journal’s Market Data Center, regular unadjusted Price/Earnings (P/E) ratios for most indexes are soaring as well.
And while I am thrilled with the market’s gains, as you might expect, this Grumpy Old Accountant couldn’t “let a sleeping dog lie.” I just had to share with you a concern about today’s market multiples, and the data upon which they are based. So what’s my beef this time? I believe that these commonly-used valuation metrics may actually be misstated, because of the poor quality accounting information on which they are founded. For example, I actually think that the P/E ratios for many companies may be higher than what is being reported today. This means that P/E ratios being cited in the press may be providing a false sense of security to investors on the future price appreciation potential of the markets.
What’s causing the potential measurement error in these metrics? The increasingly judgmental and subjective amounts being reported in today’s financial statements coupled with poor audit quality. If you think I am overreacting, just look at the continuing number of accounting errors (i.e., restatements) being reported in U.S. securities filings. According to an Audit Analytics research report titled “2012 Financial Restatements A Twelve Year Comparison,” there were 768 restatements in 2012 alone. And if that’s not bad enough, what about the repeated unfavorable critiques levied by the Public Company Accounting Oversight Board (PCAOB) against our large accounting firms for poor audit quality. Yes, it’s happened once again…this time Ernst & Young thumbed its nose at the PCAOB who responded by releasing the nonpublic portions of its July 2, 2010 report.
But before I discuss how accounting may be distorting market multiples, let’s review why these metrics are so important. Although many consider discounted cash flow modeling and analysis (DCF) the most theoretically sound approach to valuing equity securities and assets, market multiples analysis is widely used in practice. What makes these multiples so attractive? Three things: their usefulness, their simplicity, and their relevance. Valuation is about judgment, and multiples provide a framework for making value judgments (i.e., usefulness). Their ease of calculation makes them an appealing and user-friendly method of assessing value vis-à-vis DCF (i.e., simplicity). Finally, they focus on commonly used, key statistics that are considered to have the most impact in the markets (i.e., relevance). Unfortunately, however, multiples are only as good as their input (just like DCF), and the quality of their inputs is getting “more questionable” each day.
Market multiples analysis is founded on the idea that similar assets should sell at similar prices. So, if you can find a company that has a similar risk and growth profile as the one being valued, then you should be able use it as a “comparable” or “comp.” To date, many have held that the most difficult part of using multiples is in selecting comparable companies given firm-specific differences caused by such factors as industry, technology, customers, size, capital structure, and growth. But several structural developments have dramatically transformed the quality, comparability, and reliability of the inputs to market multiples, and threaten their usefulness in valuation.
First, global financial accounting standard-setters have moved from rules to principles-based accounting standards which has introduced significant judgment into “rule” application. A problem with our increasingly principles-based standards is that their lack of specific guidance can often produce unreliable and inconsistent information that makes it difficult to compare one organization with another. Are you beginning to see why my concern about market multiples is growing? You may remember that I first raised my concern about all the judgments standard-setters have forced on accountants in “Is FASB Killing the Auditing Profession?”
Complicating the matter is the fact that every major accounting firm now has its own interpretation of our new principles-based “standards.” As Francine McKenna detailed in “ Social Media’s Phony Accounting,” Ernst &Young now creates its own revenue guidelines in certain industries. I thought this was the responsibility of the standard-setters…Securities and Exchange Commission (SEC) are you okay with this?
More troubling is that we cannot rely on the independent auditor to ensure the numbers are correct. The Grumpies have weighed in on this issue numerous times (see “Arrogance or Ignorance: Why the Big Four Don’t Do Better Audits” for a summary of prior rants). Independent audits for public companies are so bad, that the auditors have auditors now (i.e., the PCAOB). So, how are we going to satisfy ourselves that even the most subjective, judgmental numbers in today’s financial statements are reliable?
So what does all this mean for market multiples like P/E ratios? First off, two companies that may appear to be keeping their books the same way, may not really be. They may actually differ in a number of ways including revenue recognition (e.g., multiple deliverables, gross vs. net, etc.), expense and loss accruals (e.g., contingencies, impairments, etc.), and fair value estimates (e.g., Level 2 and Level 3 assets). Even if you manage to find what you believe to be “comparables,” the changing landscape of accounting will complicate your life when it comes to computing your multiples. After all, much of the data in the multiples comes from the financial statements. So ask yourself…are the two companies really comparable?
Just look at the some common market multiples and their links to financial statement numbers. Any overstatement of revenue, understatement of expense, or overstatement of operating cash flows will clearly affect these well-known market metrics.
- Price/Earnings Ratio – The denominator is earnings per share (EPS), which is a function of the income statement.
- Price to Book Ratio – The denominator is book value (BV) which is a function of the balance sheet (i.e., assets less liabilities) .
- Price to Free Cash Flow – The denominator is free cash flow (FCF), which is a function of the statement of cash flows (operating cash flows less capital expenditures).
- Enterprise Value to EBITDA – The numerator is a function of the balance sheet and the denominator comes from the income statement.
Are Today’s P/E Ratios Understated?
Let’s begin by looking at some possible income statement and EPS issues that might impact the P/E ratio. My concerns here fall into three categories: revenue recognition methods, unusual revenue transactions, and expense reporting. The Grumpies have opined on all three of these individually in the past. Who can forget our work on multiple deliverables and gross vs. net reporting in “The ‘Beauty’ of Internet Company Accounting” where we lambasted the unsupported assertions and assumptions that drive such revenue recognition methods. And who uses such methods? Linked In, Demand Media, Facebook, Groupon, Amazon, Google, etc….that’s who.
Then there are unusual revenue transactions. Remember when we discussed how recent business combination accounting opened the door to creating revenue on acquisition transactions (see “Need Profit? Buy Something!”) While we focused our attention on Miller Energy, Under Armour, and Cenveo, we noted that the banking industry had become particularly adept at structuring such deals. And let’s not forget Groupon’s interesting gain on an E-commerce transaction (see “Groupon: Still Accounting Challenged”).
As for expenses, one major concern is the underreporting of impairment charges (i.e., asset overstatement) for goodwill and other intangible assets. You might recall the Grumpies piece titled “Deloitte’s Intangible Asset Clients Revisited,” in which we suggested that:
In today’s world of fair value reporting, maybe we should require companies to prove that an intangible has value (above and beyond what managers tell us)! No consulting reports based on “pie in the sky” estimates and discounted cash flow analysis allowed. Show us the actual, asset specific cash flows coming from these so called assets. Prove that they are generating above average returns. Show us the money! If you can’t, then don’t book it!
Then, there are the rosy valuation estimates made by management for their deferred tax assets. Increasingly, companies are recording tax benefits (negative tax expenses) for the reversal of valuation allowances set up to cover tax assets previously considered impaired. The effect? You guessed it…more bottom line. To show you just how common this is, we need only look to Ford Motor Company who increased its bottom line by 57 percent in fiscal year 2011 via a $11.5 billion reversal of its deferred tax asset valuation allowance (see 2011 10-K, Schedule II, FSS-1).
So, how do all of these revenue and expense examples affect the P/E ratio? Well, in each case earnings per share (EPS) was positively impacted, thus deflating the P/E ratio. Yes, I am suggesting that the “real” P/E ratios may actually be higher than reported, since revenues are routinely being overstated, and expenses understated. Two questions immediately come to mind. By how much are current P/E ratios understated, and what does this mean for our proximity to a market “top.”
What Are Today’s “Real” Price to Book Ratios?
A myriad of today’s accounting judgments also can potentially affect how “book value” is computed. Here are a few more examples of how book value computations can be damaged:
- Inflated fair value “guesstimates” for Level II and III financial assets will overstate book value.
- Unjustified cost capitalization for questionable assets like capitalized interest, software development costs, etc. overstate book value.
- Reporting of hybrid securities as equity potentially overstates book value, as does the excessive use of off-balance sheet financing.
- Current reporting guidelines for variable interest entities and equity method investments also may affect book value, but the effect direction depends on transaction specifics.
As with the P/E ratio, the move from rule to principles-based accounting has significantly increased the assumptions and judgments required for financial reporting. And the result is similar…today’s price to book ratios may be deflated for those companies engaged in aggressive financial reporting practices.
Are Today’s Price to Free Cash Flow Ratios Understated?
To answer this, you have to first answer another question. Is reported cash flow really what you think it is? Do you realize that many companies now define cash to include short-term receivables, as well as checks written and mailed but which have yet to clear the bank? If not, then check out “What’s Up With Cash Balances?” Managers are becoming increasingly aggressive at what they report as operating cash flows. When this happens, both operating and free cash flows are overstated, and the price to free cash flow is understated.
What Does the Enterprise Value to EBITDA Ratio Really Tell Us?
Great question! As you may recall, enterprise value (EV) is defined as the total value of a firm’s equity and debt (market value of common and preferred equity, minority interest and debt) plus unfunded pension liabilities and other debt-deemed provisions, less the market value of equity method investments and cash and cash equivalents. Given all of the judgment-driven accounting dilemmas raised earlier in this commentary, I am skeptical of EV’s value (pun clearly intended). And then there’s EBITDA, which also is plagued by the previously mentioned income statement issues. So, what does EV to EBITDA really tell us given its inherent subjectivity? I have no clue.
So, where does all of this leave us? Are the equity markets approaching a market top? All I can say is that our market multiples may no longer be the useful metrics we thought they were, and that the P/E and Price to Book ratios may very possibly be higher than currently stated. We are likely closer to a market top than these multiples suggest.
What is one to do about all of this? Auditors aren’t auditing and accounting standards are becoming increasingly flexible and “non-standard like.” Does this mean that market multiples should be abandoned in favor of DCF? Of course not, because DCF’s problems are twice as bad…you have DCF’s model assumptions themselves, as well as the problems with the accounting numbers!
But this grumpy old accountant has a few recommendations that might lead you through this valuation nightmare:
- Never take reported accounting numbers at “face value.” Apply analytical review procedures to determine if the amounts reported in the financial statements make sense.
- Use simple “fraud” detection models to identify comparables where the numbers may be questionable. Useful models include the Altman and Beneish models and detective ratios include the conservatism ratio, quality of earnings ratio, quality of revenues ratio, and the Sloan accrual measure.
- Compare the numbers with the company’s “story.” Do they make sense given the expectations you developed from listening to management’s “story.”
- Keep current with accounting rule changes and their impact on the financial statements.
And here are a few accounting-related final thoughts when preparing and evaluating comparables for use in market multiple analysis:
- Review the consistency of revenue recognition methods among the “comp” companies.
- Adjust for any unusual income and/or expense sources (i.e., non-recurring or not persistent).
- Reclassify reported income and expense items accordingly (i.e., impairment and restructuring charges sprinkled throughout the income statement).
- Review the balance sheet for completeness and potential valuation issues.
- Look for unusual definitions of cash and cash equivalents.
- Analyze the “quality” of reported cash flows and evaluate their persistence.
- Evaluate the company’s capital structure (debt and equity) for completeness and valuation pitfalls.
Global accounting standard-setters have diluted the usefulness of market multiples by introducing so much subjectivity into the reporting process during the past decade, that the value of these metrics themselves is questionable, and their use in comparing companies quite problematic. The shift from rule to principles-based accounting also has rendered comparison of today’s market multiples with historical metrics meaningless: it is akin to comparing apples and oranges. Or should I say rules and principles?