7.2 Perceptions of key actors on the use of financial reporting information and the impact
7.2.4 Perspectives on the uses of financial reporting information and the impact of
7.2.4.7 External users: Investors and Financial Analysts
Financial analysts and investors are the primary audience of international accounting standards. They undertake research to obtain information that will enable them to assess the value of a company over the long term, in order to identify investments opportunities and potential mispricing; namely, whether companies should buy, sell or hold securities. In this procedure, they invest in understanding financial information and gather relevant information, which includes the use of companies’ published financial statements in combination with sector data and relevant political events.
145
‘Investors and analysts use models in order to calculate the cash flow of a company and make a projection for the future, usually for the next five to ten years. They focus on cash flow statements to evaluate a company.’ [FA2]
The financial analyst’s role is to predict a company’s future performance, based on an understanding of their business plan, activities and business environment. Analysts and investors try to make sense of the production process of a company and where it is located within the industry. They try to uncover not only earnings, but also the earnings process, the distribution of sales (of subsidiaries) in geographic regions and different sectors and whether revenues match liquidity. Due to the current economic crisis and companies’ decreased profits and reported losses, liquidity is a major concern for the viability of businesses. For example, financial analysts are looking at companies that do not have loans and companies that show high liquidity in combination with the stage of the company’s economic cycle.
‘Bottom line results are important, but we put emphasis on understanding whether revenues indicate cash flows, and the factors that generate flows, taking into consideration the wider economic climate. An analysis of cash flows and the free cash flow of a company is important as well as the value of assets. Information can be extracted from the balance sheet regarding companies’ business plans, any potential takeovers in cases where there is accumulated capital or a potential selling decision in cases where there is liquidation or increased provisions.’ [FA1]
Analysts value a company according to price forecasts, targets, investment or recommendations. Valuation and financial analysis depends not only to the current market value of the security but also on other financial information; financial statement information is an input to such valuations. The most common valuation method that investors and analysts use for modelling and identifying investment opportunities nationally and internationally is the Discounted Cash Flow (DCF) analysis. In this process they assess financial instruments, project future cash flow and recommend a price target. The next step at the analysis level is to conduct relative valuations, as a way to discover low-priced companies with strong fundamentals. Fundamentals include comparative multiples for stock selection, such as the Price to Earnings ratios (P/E), to assess the relative performance of a company and compare the value of a stock to that of similar companies, as well as the market as a whole. They look at the scores they get in combination with consistent parameters, such as
146
equity, net income and other ratios for a model company.52 In terms of the valuation of operating activities these mainly use earnings and focus on the EBITDA.
‘Businesses are interested in the profits before tax and especially in the profits before interest, taxes and depreciations. EBITDA. Everything is done with EBITDA today. Banks?
EBITDA. Investors? EBITDA. The Stock Market? EBITDA. Everyone, EBITDA.’ [AUD6]
Accounting numbers and policies are not so interesting in themselves, they are more interesting in terms of what they reveal about a company’s administration. Asset values are important in terms of measuring how effective management has been at delivering profitability from assets, but flows are more important for a company valuation. Accounting standards and changes affect the final models that analysts use, while accounting needs to be intelligible. Financial analysts seem to consider that a deep knowledge of accounting is required, although their tasks are based on the use of cash flow statements. An analyst comments:
‘In order to prepare capital financial analysis 60-70% of the information is extracted out of financial statements. However, what plays an important role in our analysis is whether the company has solid foundations in order to make profits. As expected values and forecasts can be misleading we use accounting information as a compass; it is not always adequate and we have to be careful about over-borrowing and internal problems.’ [FA2]
Several interviewees mentioned how their own judgements are more important than any source of information regarding the future performance of a stock. Equally influential is investors’ judgements based on non-financial information, speculation and ‘whistle-blowing’
announcements.
‘The Greek investor decides by using less than the 50% of the fundamentals, which are related to the technical analysis, diagrams, scenarios or business stories. They decide based on the momentum, if the share price is rising, they buy. What they really care about is, of course, the profitability of the company. We try to provide information about some problems or news that the investors are probably not aware of, so we try to protect them in that sense.
Many things have happened during the last two years because of the crisis’ [FA3]
52 A model company is a top performer in terms of size; we use a scorecard to appraise companies and a ranking model for 20-30 other companies operating in the same sector.
147
‘Accounting and financial reports matter but qualitative information on the objectives, the business or the scope of the company […] are more important, and determining factors in assessing the value of the company’. [FA2]
As the stock market in Greece is less developed and investment institutions are rather small, employing a limited number of analysts, the latter do not have the time to explore finer details thoroughly investigate financial statements. Their decisions and recommendations are also influenced by the general market consensus regarding the evaluation of the company.
The workload is heavy and the amount of information is great and difficult to manage and control, especially when considering many companies at the same time. ‘Setting a price target means readjustments, follow-ups per quarter... is a large volume of work’. [FA4]
Analysts’ and investors’ judgements and assessment processes are subjective, and the type of information collected is based on the purpose of the analysis and different investment decisions. This means that financial statements are used in different ways and with different emphasis being placed on items, as well as on a different degree of detail.
‘Sometimes we do not need to go into too much depth; we may be asked to provide information about a company’s investment plan of or whether there is a particular problem […] insight and experience are vital, 80-90% is based on this. Even if one recommends a target price, they should include an element of assumption. Prices are set based on certain conditions that cannot be quantified easily or extracted from financial reports; for example, one assesses the quality of management as 20%.’ [FA2]
It should be noted here that analysts use a number of sources when executing a financial analysis. Relative valuations, for example, require additional searches to identify more up-to- date information; they are also based on information from interviews with management, company publications and online databases. As mentioned, one of the most commonly used methods of obtaining information about a company is by meeting with management. In this sense, the annual report is used to inform the investor about the quality of management and, hence, an assessment of stewardship is conducted in an instrumental way.
‘There is personal relationship with some companies and if there are questions about important issues we will contact them... We do not worry so much about Greek companies as we know our country and our mentality; we have difficulties when analysing foreign
148
companies and we are focused more on financial statements, and when there are differences among countries…’ [FA2]
Another source of information used when conducting financial analysis is trustworthy analyses conducted by other international investment institutions with greater experience and expertise.