Flash in the pan – underlying performance

19 May 2014

Investors are trying to understand your company’s underlying performance so that they can make more accurate forecasts. But some are saying it’s difficult to see what’s driving the results. World Watch interviewed Jennifer Sisson of PwC’s global investor engagement team to find out more.

What are investors telling you about their experiences in analysing underlying performance?

When investors analyse a company, they’re trying to understand the quality and sustainability of its underlying performance – they want insight into what’s driving the profits, what measures you as management think should be market-moving, what difference management actions versus market conditions are playing, and so on. Investors are telling us that they need a clear line of sight into the future areas of growth – as well as any potential problems. And our research on narrative reporting tells us that in the main, they’re not getting that clarity. Our 2013 reporting survey showed that only 33% of companies clearly explained and quantified the underlying drivers of financial performance. Some investors are saying to us that they can’t tell where growth is coming from or whether, for example, it’s organic or acquired growth.

Why aren’t companies providing all the information investors need – surely it’s in their interest to do so?

That’s right – it is. Telling the real story of your performance, transparently, builds trust. You’re effectively saying “We’re not just a flash in the pan, and here’s why”. By reducing forecasting uncertainty and building trust, you’re lowering the cost of capital for your business. It’s not a matter of companies deliberately hiding information away – in many cases, companies do provide all the information, but maybe they’re not being clear, the key messages are buried, they presume too much prior knowledge of the industry or they’re not providing insight into the dynamics of what drives the business. When you live and breathe an industry and spend all your time grappling with delivering value in a complex business environment, it’s all too easy to forget that others are less familiar with your working world!

“...only 33% of companies clearly explained and quantified the underlying drivers of financial performance.”

So how can companies provide that context?

Some companies are getting better at providing it in investor presentations and on analysts’ calls, but that’s not being replicated in annual reports – it’s really important to consider how you keep a consistent, clear and concise story across all your channels of communication. The first thing to do is to think about the questions you’re trying to answer. How have you explained the drivers of your financial performance – have you actually said plainly how you create value? How sustainable is your profit or cash generation? Is that realistic in the external market in which you operate? Investors tell us that they want to see discussions of market trends and impacts over time, preferably including some historical data, tied back to future targets. Then there’s presentation – visual representations can be a really useful way of getting lots of detail across quickly. ‘Bridge charts’ can help investors understand what’s driving growth in revenue and profit. There are some companies that are experimenting with their financial statements – consolidating notes and putting more information into them, making the key information more prominent. So there are areas where companies have to include new or better information, and then areas where they can make an effort to present that information better.

What about reporting on alternative performance measures – that is, amounts not based on Generally Accepted Accounting Principles? Does that make analysis harder for investors?

No – that’s not what we’re hearing. Investors are very clear that non-GAAP measures can increase their understanding of the business, and that IFRS reporting isn’t the ‘Holy Grail’ for them. Many believe that there are plenty of companies that actually can’t adequately explain what the business has been doing without using non-GAAP measures. They say that those measures can really complement standard IFRS measures and give clarity on things like the impact of foreign exchange movements. But whilst non-GAAP information can provide valuable insight into a company’s performance, investors are telling us that where they’re not portrayed in a balanced and responsible way, this can really damage a company’s credibility.

So how can companies use non-GAAP measures and be confident that they’re not harming their reputation?

One of the big themes from our surveys – and from events like Meet the Experts - is that investors say non-GAAP information is important, but it would be helpful to know that some ‘ground rules’ have been applied so that they can gain comfort in relying on the data for their analysis. The messages are pretty simple really; to distil it down to six shoulds and shouldn’ts: first, companies should be clear and consistent in their definitions of the measures and adjustments. They should only use those measures that are really relevant for understanding performance, not just measures that present a more attractive number. They should reconcile to the relevant IFRS counterpart in the statements, showing the adjustments clearly, and providing a narrative where possible. In fact, the explanations management give for why they have adjusted for various amounts can be quite insightful for investors and analysts. It is also crucial for management to provide comparative data and restatements whenever the definitions change. One of the other things we hear is that balance is important, and companies should think about how they give prominence to their IFRS vs. non-GAAP figures in all communications – and particularly, they should be very clear about which measures are non-GAAP, and what is and isn’t audited.

On that last point, what is the demand for assurance over non-GAAP measures?

In our survey, the investment professionals we interviewed expressed strong support for robust assurance over the ‘metrics that move markets’ – most notably non-GAAP and industry-specific metrics such as adjusted earnings, same-store sales, pipeline data and so on. They say that the reliability of that kind of data is important because it’s used for building economic models, which drive investment actions that move the markets. Some investors are saying that they want all financial information to be audited, whether IFRS or non-GAAP. One told us that they simply want the auditors to say “Yes, they did actually calculate it the way they told you they were calculating it”.