Corporate Disclosure Issues:
Analysis of the value of shares based on a company’s fundamentals (including earnings, sales, assets and liabilities and growth rate) depends on adequate and fair disclosure by the companies. Unfortunately, current disclosure practices leave a lot to be desired. The following is a list of issues where companies frequently do not provide an ideal level of disclosure.
Earnings Forecast Disclosure:
Why is it that investors rely on analysts to project the earnings of companies? Clearly, the company itself is in a much better position to estimate its own future earnings. The problem is that the companies are afraid of being sued by investors if earnings take an unexpected turn for the worse.
I think that the entire framework of disclosure of company future earnings forecasts in Canada and the U.S. is a ridiculous charade. The reason is that earnings forecasts are ostensibly provided by independent analysts. However, I think that these analysts are usually not independent. I think that they usually base their estimates on an earnings forecast that they have obtained from management. They even have a name for it, they call it “guidance”.
The companies do not make public their own profit estimates. But, most analysts are in close contact with the subject company when they develop their earnings estimates. But investors are supposed to believe that the company does not disclose its own estimates of profitability to the analyst. And, this is in spite of the fact that the company very much wants the analyst to predict the “correct” number. I believe that most companies routinely disclose their own internal earnings estimates to Analysts. In some cases the company will do so publicly.
It is illegal under securities laws for companies to disclose material facts that would have a material impact on the share price without making that information public. Unfortunately, disclosing information to a group of analysts in a conference call during business hours is considered public disclosure. This puts retail investors at an information disadvantage. Also, I suspect that most companies routinely disclose important information, such as profit estimates, to individual analysts as normal practice. I can only assume that such selective disclosure is allowable under the laws. When I called companies a number of them spoke freely to me about their earnings estimates and other information that had not been made public. Companies want analysts to get the estimates right and avoid “surprise” earnings in a negative direction. The analyst also wants to get it right. Under this system, the temptation for the company to disclose important information to the analyst must often be irresistible.
It also seems rather silly to think that employees of public companies are not routinely providing the company’s internal earnings estimates to their friends and acquaintances. It becomes a judgment call as to whether or not this constitutes illegal insider trading. It would not be an issue if management simply disclosed their earnings estimates to the public on an ongoing monthly basis.
My conclusion is that the whole system is wacky and is not serving retail investors well. I would prefer companies to disclose revenue, earnings, and capital investment forecasts on at least a quarterly basis (and preferably monthly) through their Web sites and press releases. Disclosure should not be limited to “material” items since that leaves far too much room for abuse. Ideally such releases would be posted after trading hours to give all investors time to access the information before the market opens.
Best practice: Earnings are released after trading hours. Retail investors are given advance notice of the “analyst” conference call and may participate. The call is broadcast on the We. The full transcript of the call, including the questions and answers, is posted for later viewing on the Web or a recording is made available at a toll-free dial in number.
Poor Practice: Earnings are released during the trading day. Retail investors are not informed about the analyst call. No transcript is available.
Disclosure of Insider Trading Reports:
Companies are required to file insider trading reports with securities regulators. But they are not required to file them until some weeks after the fact. And the securities regulators generally do a very poor job of making these accessible to the public. For example, these reports are not included on the Ontario Securities Commission’s SEDAR Web Site. Instead the Securities Commission provides this information to certain parties (at a fee I presume) and those parties then make those reports available to analysts and investors for a fee. This system works quite poorly for individual retail investors.
Best Practice: The company immediately posts insider trades to its Web Site, or issues periodic press releases with the details. I know of no examples of this.
Normal (Bad) Practice: The company complies with the regulation by sending the reports, on a delayed basis, to the regulator and does nothing further to make these reports available to investors.
Disclosure of earnings before unusual gains and losses:
Companies are required to report the affect of certain extraordinary items on an after tax basis. However there are often a number of other unusual and one-time items that are affecting net income. Companies vary widely in there disclosure of such items. Investors need to know the normalized earnings since that forms the best starting point to calculate a P/E or from which to forecast future earnings.
Best practice: The company indicates the normalized net income after all unusual items on an after tax basis. This estimate is provided in the 5 or 10 year summary information as Ill. Example BCE provides “baseline” earnings.
Normal practice: Some mention is made of unusual items but not on an after tax basis and the normalized earnings are not provided.
Poor practice: No particular attention is drawn to such unusual items.
Disclosure of net income:
Investors are interested in the net income applicable to common shares.
Best Practice: Net income is always given top billing ahead of other similar sounding measures like net income before unusual items, operating income, cash flow, and EBITDA (“Earnings” Before Interest, Taxes, Depreciation and Amortization). Where preferred dividends are paid the company always focuses on net income applicable to common shares and not on net income before preferred dividends.
Poor Practice: Many companies focus on things like operating income or discuss net income when, due to the existence of preferred dividends, they should be discussing net income applicable to common shares.
Disclosure of prior years financial summary:
Best practice: Provide at least 6 years data and preferably 11 years data so that analysts can calculate the growth over 5 or 10 years. In graphs show increases in income and sales on a per share basis.
Poor practice: Only the strictly required two years of data is provided. Graphs may show sales and /or income increasing while sales per share are actually declining due to share issues.
Disclosure in Quarterly Reports:
Best Practice: A detailed quarterly report is provided. It includes full unaudited financial statements. It includes a management discussion. The press release contains the full text and financial statements. The average and final numbers of shares outstanding are provided. The annual report provides a summary of the quarterly results.
Poor Practice: The balance sheet is omitted from the quarterly report. A press release is issued which does not contain the full data from the quarterly report. The number of shares outstanding is not provided. The annual report does not contain a summary of the quarterly results and therefore analysts cannot rely on the annual report as a stand-alone document for that year.
Disclosure of information in the annual meeting circular:
This circular contains important information including the existence of a controlling shareholder, names of Directors, share holdings of directors, and executive compensation and stock options.
Best Practice: Ideally this document would be posted to SEDAR and to the company Web site.
Poor Practice: The normal practice of sending this out only to registered shareholders prior to the annual meeting.
Cash Flow:
So-called “cash flow” is disclosed in the financial statements. In the simplest cases it consists of net income plus depreciation and amortization, which are added back to net income since it is a non-cash expense. Other items added back would include losses on disposal of assets and “write downs” of asset values and restructuring expenses that have not yet actually been incurred. Changes in accounts receivable and accounts payable balances are also added back, but generally a sub-total is provided before that item since an increase in cash caused by an increase in accounts payable is not comparable to cash generated by net income.
A major problem with this definition of cash flow is that it is often fairly meaningless. Investors need to know how much of that cash flow had to be reinvested in fixed assets to sustain the company. Cash flow less sustaining investments can be called “free cash flow”.
Best Practice: The cash flow statement would separate capital investments into sustaining investments and investments in growing the business. Free cash flow would be disclosed. I know of no examples of this practice.
Normal practice: The standard cash flow statement is provided.
Poor practice: The company does not bother to provide the sub-total before the changes in non-cash working capital.
Unrealized Gains on Investments:
Some companies have substantial unrealized gains based on shares they hold in other publicly traded companies. In extreme cases such as Power Corporation of Canada the value of the company’s shares is largely determined by these unrealized gains rather than by the reported earnings of the company.
Best Practice: These unrealized gains should be disclosed.
Poor (but normal) Practice: These gains are not provided even when they are extremely large.
Unrealized Gains and Losses on Assets:
There are some companies where the unrealized gains or loses on their assets would be material. In the real estate industry it would be important to know if the book value of the companies buildings is substantially less than or greater than the market value of those buildings. In fact, many real estate companies suffer from quite low profitability. But the assumption is that the profitability is understated since the buildings are not depreciating or are even appreciating in market value. This seems to be the justification when real estate companies add back depreciation and to focus on “cash flow” rather than on net income. A far superior system would be for the real estate company to provide supplemental information on the unrealized gain in market value. With the move to market value as the basis for municipal tax assessments, this should be easy to implement.
Best Practice: Provide details on major asserts such as buildings, include the age of the building its market value, its assessed value. I know of know cases where this is done.
Normal Practice: Disclose net income but focus on cash flow, bemoan the fact that investors don’t understand that the real net income is much higher than the accounting net income.
Written approximately 2001