Show me the money
In looking at company financial statements, one useful question to ask is how cashflows compare with earnings. At the end of the day, cashflows are what give a company its value, but valuation tends to focus more on accounting earnings.
There are good reasons for this – if the company undertakes activity this year that will translate directly into cash inflows next year, it’s reasonable to recognise that activity this year’s P&L. A good illustration might be a forestry business that carefully tended to its trees this year, and will harvest them next year. This year’s accounts will show the costs incurred in tending to the trees, and also some recognition that the value of the trees increased over the course of the year.
This process of recognising change in the value of balance sheet asset is called accrual, and it’s a perfectly reasonable thing to do. However, it’s also open to abuse by managers who might have an unduly rosy view of the future. Until the cash actually flows, amounts shown as accruals in the P&L can only ever be estimates.
In Australia, this can be a particular concern for project-based contractors. The accounts for these businesses will typically include the revenue management anticipates it has earned over the year, on projects that may have some way to go before completion.
If management has overestimated its progress, or underestimated the costs involved in completing the project, then the accounts will start to part company with reality. Having seen how things can go awry in these circumstances, we apply a couple of principles to investing in companies with significant accruals:
- We need to be comfortable that we understand what the accruals represent; and
- We need to believe that management is of sound character.
These are not always easy questions to answer, and as a result we will probably miss out on some good investment opportunities by erring on the side of caution. C’est la vie.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
