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?


This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.


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AuthorAnthony Catanach

As many of you might suspect, this grumpy old accountant is not a big fan of last year’s JOBS Act.  As so eloquently communicated by Andrew Ross Sorkin in “JOBS Act Jeopardizes Safety Net for Investors,” my primary concern is the decreased amount of time that investors now have to analyze critical corporate information.  Three weeks is simply not enough to evaluate the financial viability of a company before it goes public.  As Mr. Sorkin suggests, the Act:

dismantles some of the most basic protections for the most susceptible investors apt to be drawn into get-rich-quick scams and too-good-to-be-true investment ‘opportunities’.

So, when Model N founder and CEO Zack Rinat told Maxwell Murphy at the CFO Journal recently that the Company believes in “complete transparency,” and won’t use the JOBS Act to hide material information from investors, I just had to take a look.  Now I can’t promise the Company that it would have avoided my scrutiny had it gone through the normal IPO filing process, but it sure would have gotten some good comments that would truly have helped the CEO honor his transparency pledge to investors.  My review of Model N’s Amendment  No. 4 to Form S-1 Registration Statement filed on March 15, 2013 (S-1), did not disappoint.

Two things immediately tipped me off that this was going to be an interesting read.  First, there was the unlabeled circular graphic presumably depicting the life cycle of revenue management using the Company’s solutions that preceded the table of contents.  Not until page 86 of the S-1 does the Company actually attempt to explain this illustration.  Then, there was the Company’s motto, “More Revenue, Made Simple.”  I found this marketing hype particularly annoying since it challenges the intelligence of experienced business professionals who recognize there is nothing easy about creating customer value.  So, right out of the gate we have transparency issues.

Next, there is the issue of what the Company actually does.  The reader must wade through page after page of MBA speak (85 pages in fact) to learn what the Company’s strategy and business model is.  Why mystify us with such terms as “revenue management solutions, strategic end-to-end process, application suites, and domain expertise” when the Company is nothing more than another software provider attempting to remedy the age old problems of transaction processing, reporting, and system integration.  Why all the marketing spin, legalese, and accounting verbosity?  All of this detracts from transparency. 

Then, there are the numerous questions raised by the Company’ s historical operations.  We learn early on that an investment in Model N is quite risky (S-1, page 4).  Recent operating losses, dependence on a few key customers (75 percent of revenues come from 15 customers), reliance on a single product, and a single industry focus all make this grumpy old accountant wonder what makes this Company “worthy” of an IPO.  

And then you have the declining margin issue masked in the Summary Consolidated Financial Data (S-1, page 8).  Margins on license and implementation products have decreased from almost 62 percent in 2010 to 54.81 percent at the end of the most recent fiscal year end. Why is this? Wouldn’t it be more transparent to explicitly report this very troubling trend in the introductory summary table?  

Instead, we don’t even see these negative margin trends until page 59 of the S-1.  Sure, Model N provides exhaustive detail of revenue and cost of goods sold changes, but it does so without answering the million dollar question: why the margin erosion?  Excuse me, but this is a pretty significant transparency deficiency.

And of course, as with so many IPO’s today, the Company feels compelled to spin its losses into profits via non-GAAP performance metrics (i.e., adjusted EBITDA).  When we get to the EBITDA reconciliation (S-1, page 10), we learn that the biggest reconciling item is for something called “LeapFrogRx compensation charges,” but the LeapFrogRx transaction has not been detailed up to this point in the S-1.  Again, is this what transparency is all about? And this is significant.  If not for the LeapFrogRx compensation charges and stock-based compensation, there would have been no need for “adjusted EBITDA” at all!  By the way, the LeapFrogRx transaction is not even mentioned until page 49 of the S-1, and we don’t get any of the specifics until much later in the actual financial statements (S-1, F-21 and F-22).  

As an aside, I particularly got a kick out of the Company’s justification for paying an excess purchase premium for LeapFrogRx: synergies in skill-sets, operations, customer base and organizational cultures.  Goodwill impairment can’t be far behind, can it?  And, oh by the way, why is stock-based compensation going up as the Company begins to lose money (S-1, page 9)?  Another transparency issue?

As I navigated the Company’s risk factor section (S-1, page 15), I was stunned to see accounting policies listed as a risk factor!  Essentially, Model N is “warning” potential investors that its reported revenues may be lower than they “really” are because of accounting.  Specifically: 

Our revenue recognition model for our cloud-based solutions and maintenance and support agreements also makes it difficult for us to rapidly increase our revenues through additional sales in any period, as a significant amount of our revenues are recognized over the applicable agreement term.

Does the Company require a specific type of accounting to report profitability? Unbelievable! Such disclosure does little to enhance transparency.

And the Company continues to imply that accounting will somehow “hurt” the business (S-1, page 31) in the following risk disclosures:

Our financial results may be adversely affected by changes in accounting principles generally accepted in the United States...If our estimates or judgments relating to our critical accounting policies are based on assumptions that change or prove to be incorrect, our operating results could fall below expectations of securities analysts and investors, resulting in a decline in our stock price.

Why is the Company warning us so much about the accounting?  Is there a problem?  Should we even be relying on the S-1?  Again, transparency sure seems to be an issue.

And if Model N is so transparent, why did it take advantage of certain exemptions from reporting requirements that public companies make, including not complying with auditor attestation requirements of Section 404 of Sarbanes-Oxley, reduced disclosure of executive compensation, etc. (S-1, page 32).  And then there is the issue of how Model N management intends to use the funds received in the IPO.  Surely, a Company wouldn’t do an IPO if it didn’t have some idea of how the proceeds would be used.  Yet, once again, Model N fails the transparency test by not telling us its plans for the monies raised (S-1, pages 36 and 41).

And then there are the bookkeeping errors (S-1, page F-18).  Is it really transparent to label accounting mistakes as “out-of-period adjustments?”  You make the call.

Finally, it is noteworthy that Model N reported income tax expense in 2012 even though it reported a pre-tax loss for the period.  The reason: a significant increase in its valuation allowance for deferred tax assets suggesting poor future operating performance prospects even with an IPO (S-1, F-32).  Then there is the issue of whether the IPO will trigger Section 382 limitations on the Company’s net operating loss carryovers.  While the Company does identify this as a risk (S-1, page 34), it seems to suggest that this “might” occur when in reality the likelihood is significantly greater than might.  This disclosure clearly plays down the loss of this asset, and again causes one to question the Company’s transparency.

Sujan Jain, Model N’s CFO, in the aforementioned CFO Journal indicated that filing offering plans confidentially with the SEC allowed the Company to avoid distractions of early IPO publicity.  You tell me…are the issues I raised “distractions?”  I think not…and to take a page from the beloved radio announcer Paul Harvey, “and now you know the rest of the story.”
But there’s more.  Earlier this week, Model N issued a press release to report its second quarter fiscal year 2013 results.  And once again, the Company disappointed us with its lack of transparency by introducing new non-GAAP metrics: non-GAAP gross profit, non-GAAP research and development expenses, non-GAAP sales and marketing expenses, and non-GAAP general and administrative expenses. Clearly, Model N is learning the new IPO game. But is this accounting-conflicted, non-GAAP focused, JOBS Act loving Company transparent?

This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.


Posted
AuthorAnthony Catanach