VALUE INVESTING
Accountancy – Here's the Drill

By Stephen Bland (TMFPyad)
October 1, 1999

Anatomy class over for the time being, accountancy classes are now starting.

There are many books available on how to interpret company accounts, and much has been written elsewhere on the Fool about this topic. Value players do need some understanding of accounting matters, if only to appreciate the meaning of the expressions used in publications that present company results, such as the Investors Chronicle and all the other paper, CD and web-based media.

The reasons why some knowledge is required are fairly clear really. As value investors we rely on accounting data, amongst other stuff, to determine whether a share fits the required criteria. Taking my pyad approach, all those four bits of information which form the basis of whether I even start to turn on to a share, and which test whether it's worth even getting out of bed for, are derived from the accounting information presented by the company.

All UK companies, publicly quoted or otherwise, are required by company law to prepare annual accounts. The content of those accounts is governed primarily by that law. Additionally, the accounting bodies lay down standards for certain accounting policies regarding the methods of calculation, disclosure and presentation of a wide range of matters that affect the amount at which the profit and asset and liability figures in the accounts are stated. The accounts must comply with those standards and the auditors have to comment upon any significant departure in the accounts from those rules.

All UK public companies are subject to audit by an external firm of registered auditors, which will almost always be a firm of chartered accountants. The general job of the auditors is to report to the shareholders upon whether or not the accounts are true and fair in the sense of the amount of profit and the values at which assets and liabilities are disclosed, plus compliance generally with accounting standards. Auditors are sometimes heavily criticised but in fact, although not of course infallible, they perform a vital role for us, the shareholders, in providing a degree of comfort as to the reliability of the published accounting information.

So, to anyone reading company reports directly, as distinct from abstracts of figures in other publications, always read the auditors' report. In most cases it will confirm the "true and fair" view. But sometimes you will find further comment or, more rarely, a qualification. If you discover anything like this be careful. It may suggest that the accounts are not all that they should be or it may be something innocuous which the auditors decided must be brought to the attention of shareholders, even though it does not destroy the quality of the accounts.

I'll look now at the four pyad criteria from an accounting viewpoint.

P

The bit of the P/E ratio that depends on accounting is of course the E – earnings per share. This is crucial to me and should be to most value players except pure low P/BV types. The basis of this can vary. The company will publish the historical audited version. This is simply the profits after tax divided by the number of shares issued. Simple? Not always, unfortunately. If you read analysts' figures on the company you may see two versions of the historical EPS. There will be the company's own figure taken from its accounts, sometimes shown by analysts as "FRS3." There may also be a "normalised" version as well. Which do you take?

FRS stands for Financial Reporting Standards. These are amongst the accounting standards to which I referred above that determine the presentation of published accounts and try to enforce uniformity to reduce the incidence of creative accounting. FRS3 is the particular standard on earnings per share. Published accounts will therefore declare eps on this basis. However analysts will often try to restate the figure by pulling out what they consider to be non-recurring items to arrive at the underlying and assumed sustainable EPS arising from the company's normal trading activities, excluding any isolated transactions that occur sometimes in a company's business. This they will call the "normalised" EPS.

There can on occasion be a huge difference between normalised and FRS3 EPS. Here are the actual figures for the last three years on a particular company, Caledonia Investments, that someone happened to mention on the value shares board recently.

1997 Normalised 37.5p
           FRS3 68.3p

1998 Normalised 33.7p
           FRS3 31.0p

1999 Normalised 12.5p
           FRS3 79.2p

Staggering, eh? So what do you do? Take the normalised version is my advice. But you won't find it in the company's accounts, only in analysts' opinions. Forecast EPS will also be on a normalised basis so in order to compare like with like we are compelled to use the normalised basis anyway. Forecasts are very important to my style, as I have written, even though I take them with a large degree of scepticism. They are an indicator of the likely trend and this is critical to successful value investing in my view.

Y

Yield, the percentage ratio of the annual dividend to the share price. Probably the only absolutely reliable piece of information in the whole of the accounting data available. The reason is simple. It is not someone's opinion, like so much of accountancy, but pure cash. You cannot argue with that and there is little more to be said about it.

A

Assets per share. Same as shareholders' funds or book value per share. This is derived from the balance sheet of the company. Assets and liabilities are in general stated at cost price less depreciation. Depreciation is not a cash expense but a process of spreading the cost of the item over several years in accordance with its expected useful life. Depreciation is therefore an estimate.

Exceptions to this rule may be properties and investments which are often revalued to market value in accordance with applicable accounting standards.

Assets may be tangible or intangible. Tangible assets are things you can kick, or almost. Examples are property, plant and machinery, vehicles, debtors, stock, bank balances and investments etc. It is hard to kick intangibles because they consist of stuff like goodwill and patents.

Goodwill often causes problems for investors looking at asset value. It arises most commonly upon an acquisition at some earlier date and represents the excess over book value paid by the buyer. So assume you are Value Plc and a year ago you bought Overpaid Ltd, paying £1m for it. The assets of Overpaid Ltd are estimated by you to be worth £700,000. As a result the excess of £300,000 is known as goodwill. Investors in Value Plc will see the intangible asset of goodwill at this figure in the balance sheet. Accounting standards require that the goodwill is written off over a period of years so the balance sheet valuation will be progressively reduced, with certain rare exceptions.

It is questionable whether the book value for asset players should include intangibles. Many analyst sources quote net asset value on both bases. Personally I exclude it from my opinion of the book value of the company. It is the more conservative view to do this, so it is safer and therefore helps in minimising the downside.

It is very important for investors to realise that book value does not represent market value. It does not mean that the company could be sold for its book value. It may be worth a lot less, or a lot more, there is no clear rule. It is not the accountants' or auditors' job in company accounts to produce a balance sheet that gives the estimated market value. It is not even an unwritten or tacitly accepted interpretation of a balance sheet.

So all book value per share really tells you is merely what the net balance sheet valuation of the assets less liabilities per share amounts to. But it is some guide for comparison between different companies. The norm is for companies to trade at a considerable premium to book value. It therefore follows that companies trading at under book value may sometimes be attractive because the market is giving them a very low rating.

D

Debt is shown on the balance sheet as a series of liabilities analysed by the dates it is repayable. It is a negative component of the above mentioned net book value because it is a liability comprising the money owed by the company to banks, loan stock holders and similar. I prefer there to be no debt whatsoever and in fact for the opposite, loads of net cash, to be present. Again the latter can be found on the balance sheet as an asset. "Cash" includes bank balances and near-cash items such as quoted investments, but not unquoted investments or assets such as property.

A certain amount of debt may be acceptable to me if there is a more than compensating amount of cash, hence the term "net" cash, ie. after deducting debt. But the greatest situation, for me, the event that causes the tongue to hang out, shortage of breath, dilation of the pupils and other evidence of sexual arousal, for discussion of which this article is perhaps not a suitable place, is pots of cash and no debt at all. Such a company is immensely strong and therefore has its downside well and truly minimised, and in addition and thrown in for nothing, is a powerful magnet for a bidder.

Next week – I don't know yet. Don't miss it.

Comments and questions to the Value Shares board, please.