RELATIVE IMPORTANCE OF COMPANY FINANCIAL STATEMENTS IN INVESTMENT ANALYSIS Albert JM Bruinette A dissertation submitted in part fulfilment of the requirements for the degree of Masters in Commerce in the Faculty of Business Management RAU Study leader: Professor Aard Boessenkool Faculty of Business Management Johannesburg July 1998
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RELATIVE IMPORTANCE OF COMPANY FINANCIAL
STATEMENTS IN INVESTMENT ANALYSIS
Albert JM Bruinette
A dissertation submitted in part fulfilment of the requirements for the degree of Masters in
Commerce in the Faculty of Business Management
RAU
Study leader: Professor Aard Boessenkool
Faculty of Business Management
Johannesburg
July 1998
OPSOMMING
Die waardering van maatskappye, hetsy privaat of genoteerd, is ingewikkeld.
Dit is deels so omrede die faktore wat die waarde van 'n maatskappy bepaal
of beinvloed nie altyd bekend of duidelik is, aan die belegger.
Die belegger in maatskappye het toegang tot 'n wye verskeidenheid van
informasie bronne wat betrekking hou op 'n spesifieke maatskappy. Die
belegger moet keuses uit oefen van watter informasie branne gebruik gaan
word in die waardering van maatskappye. Die belegger moet hierdie keuses
maak as gevolg van beperkte hulpbronne beskikbaar.
Die finansiele state van 'n maatskappy is een van die informasie bronne
beskikbaar op 'n betrokke maatskappy, Die is van belang om die
belangrikheid van finansiele state as informasie bran in terme van nuttigheid
(uitwysing van waarde drywers) en toepaslikheid vas te stel.
Die studie beveel die relatiewe waarde van finansiele state aan by die
belegger. Die finansiele state van 'n maatskappy voldoen aan die vereistes
van nuttigheid en toepaslikheid wanneer finansiele state gebruik word om
maatskappye te waardeer. Die nuttigheid an toepaslikheid van finansiele
state word egter beperk onder sekere omstandighede en die belegger moet
kennis dra van hierdie omstandighede.
ii
ACKNOVVLEDGEMENTS
An extra special word of thanks to my mother, Andri Bruinette, for herconfidence in my abilities. Also for Marisa for her very real support during thelast two years. This study would never have seen the light of day without thesupport you have all given me. A word of thanks to my study leaderProfessor Aard Boessenkool for his advice and guidance.
iii
CONTENTS
OPSOMMINGACKNOWLEDGEMENTSCONTENTS
CHAPTER 1: STATEMENT OF THE PROBLEM1.1. Introduction1.2. Problem statement1.3. Study objectives1.4. Methodology1.5. Limitations of study1.6. Demarcation of the study
CHAPTER 2: LITERATURE ON SOURCES OF INVESTMENT INFORMATION
(i)(ii)(iii)
16799
10
2.1.2.2.
2.2.1.2.2.2.2.2.3.2.2.4.2.3.
2.3.1.2.3.2.2.3.3.2.3.4.
IntroductionQualitative characteristics of investment informationUnderstandabilityRelevanceReliabilityComparabilitySources of investment informationMarket indicesBrokerage firm research reportsNewspapers and magazinesAnnual company report
1213141415161718192021
CHAPTER 3: LITERATURE ON THE RELATIVE IMPORTANCE OF FINANCIAL STATEMENTS3.1. Introduction 243.2. Financial ratios 25
3.2.1. Profitability ratios 263.2.2. Debt management ratios 273.2.3. Market value ratios 283.3. Du Pont analysis 293.4. Economic Value Added 31
3.4.1. Cost of capital 323.4.1.1. Cost of debt 333.4.1.2. Cost of equity 343.4.1.3. Risk 35
3.4.1.3.1. Calculation of risk for listed companies 363.4.1.3.2. Calculation of risk for unlisted companies 37
CHAPTER 4: QUALIFICATION OF THE RELATIVE IMPORTANCE OF FINANCIAL STATEMENTS4.1. Introduction 424.2. Creative accounting 42
4.2.1. .Acquisitions 434.2.2. Disposals 444.2.3. Deferred consideration 454.2.4. Extraordinary and exceptional items 464.2.5. Off balance sheet finance 474.2.6. Contingent liabilities 484.2.7. Capitalisation of costs 494.3. Case studies 50
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CHAPTER 5: CONCLUSIONS AND RECOMMENDATIONS5.1. Conclusions
5.1.1. Qualitative characteristics5.1.2. Companyvaluation models and tools5.1.3. Creative accounting5.1.4. Relative importance of financial statements5.1.5. The role of the human factor in investment5.2. Recommendations
The value of financial statements to stakeholders in a particular company differ from
stakeholder to stakeholder. There are numerous stakeholders involved in a particular
company. These numerous stakeholders interests are different for a particular company.
This diverse interest in a particular company by the various stakeholders result in the
different utilisation of the financial statements by the different stakeholders. The different
utilisation of the financial statements by the stakeholders lead to different values being
attached to financial statements by the numerous stakeholders. .
The following are but some of the stakeholder groups involved in a particular company;
• Management
• Employees
• Credit lenders and providers of credit
• Clients
• Governmentand regulating bodies, and
• Shareholders, analysts and investors
Information demanded from financial statements are different for the particular
stakeholders (Foster, 1986:2-9). This is because the source of the demand are different
for the particular stakeholders.
One source of demand for financial statement information by management arises from
management incentive contracts. The salaries of key management salaried employees
could be based upon pre-established corporate goals for return on invested capital. This
performance related management incentive contracts establish direct links to the
company's financial statements. Management also utilise financial statement information
in many of their financing, investment and operating decisions. A financial statement
"
based ratio such as the debt-to-equity ratio or interest coverage ratio is very relevant in
the decision of how much long-term debt to raise.
The demand for financial statements by employees can arise from several motivations.
Employees can have a vested interest in the continued and profitable operations of their
firm. The financial statements are an important source of information about current and
potential future profitability and solvency. Employees can also demand financial
statements to monitor the viability of their pension plans (Foster, 1986:2-9).
In the ongoing relationship that exists between credit lenders and a company, financial
statements can play several roles. In the initial loan granting stage of the relationship,
financial statements typically are an important item. Indeed, many banks have standard
evaluation procedures that stipulate that information relating to liquidity, leverage,
profitability, and so on are to be considered when determining the amount of the loan, the
interest rate and the security to be requested. If the decision to grant a loan is made, the
terms of that loan may contractually stipulate that financial statement variables be an
important factor in determining the nature of the ongoing relationship. Many bank loans
include bond covenants that, if violated, can result in the bank restructuring the existing
loan agreement.
The relationship between a company and its clients can extend over many years. In
certain cases, these relationships take the form of legal obligations associated with
guarantees, warranties, or deferred benefits. This was the case where coal mines were
explored and mined solely for supplying coal to a particular Escom power plant (South
Africa's electricity utility). In other cases, the long-term association is based on continued
attention to customer service. Customers have a vested interest in monitoring the
financial viability of companies with which they have long-term relationships. This interest
is likely to increase when concerns develop about possible bankruptcy. The financial
statements of the company represent one source of information that customers can use to
make inferences about the viability of the company.
Demand for financial statement information by government and regulating bodies are
diverse. But one such area is that of revenue collection inter alia income tax, sales tax or
...value-added tax. To have a more effective revenue collection, government requires
insight into the financial statements of companies in order to determine the various taxes
owed to government (Foster, 1986:7). Financial statements is but one input into decision
making process for government. Other inputs such as political factors also may be
equally if not more important in some cases inter alia determining whether to approve a
government-backed loan guarantee or the policy platform of the. party in power.
Shareholders, analysts and investors demand for financial statement information is
huge. These parties require information in order to make decisions on which securities
(shares) to buy, retain or sell (Sharpe, 1981:533-544). These decisions are not limited to
which shares but also the timing of the purchases and sales of particular shares.
Shareholders, analysts and investors require information on companies, of which financial
statements are but one source of information, to value the securities of companies and
therefore make informed investment decisions .
The valuation of securities listed on a stock exchange by shareholders, analysts and
investors over the years have lead to several methods being developed. Some of these
methods have proved to be more effective than others. In general, the evaluation of
securities may be divided into two main categories, namely Technical and Fundamental
Analysis.
Technical Analysis involves the examination of past market data such as prices and the
volume of trading, which leads to an estimate of future price and, therefore an investment
decision. Whereas fundamental analysts use economic data that are usually separate
from the market, the technical analysts believes that using data from the market itself is
good because "the market is its own best predictor" (Joffe, 1995).
Technical analysis does not concern itself with the reasons for share price movements but
concern itself with the study of share price movements on the stock exchange (Sharpe,
1981:544-550). Technical analysts see no need to study the multitude of economic and
company variables to arrive at an estimate of future value because past price movements
will signal future price movements. Technicians also believe that a change in the price
trend may predict a forthcoming change in the fundamental variables such as earnings
...and risk earlier than it is perceived or anticipated by most fundamental analysts.
Technical analysts believe that all fundamental information is already factored into the
charts (graphs).
Joffe (1995:21-26) says that by analysing the different charts (graphs) inter alia showing
price behaviour, volume of transactions, new highs and lows, moving averages and
cycles, technical analysis attempts to identify areas of 'support' and 'resistance' as well as
future trends and potential price levels.
Technical analysts support the view "the market is its own best predictor" on the
assumption that the market value of any goods or services are determined solely by the
interaction of supply and demand. In fact, technical analysis is often termed demand and
supply analysis (Sharpe, 1981 :545). Supply and demand are governed by numerous
factors, both rational and irrational, inclUding factors such as opinions, moods and
guesses. The market react then to all these factors continually and automatically.
The technician usually attempts to predict short-term price movements and therefore
making recommendations concerning the timing of purchases and sales. Technical
analysis therefore concentrates on the short-term characteristics of specific securities or
of securities in general (Stevenson & Jennings, 1981 :207-219). It is sometimes said that
fundamental analysis is designed to answer the question "What?" and technical analysis
to answer the question "When?".
Technical analysts claim that a major advantage of their method is that it is not heavily
dependant on financial accounting statements - the major source of information about the
past performance of a firm or industry. The fundamental analysts evaluates financial
statements to help project future return and risk characteristics for industries or individual
securities.
Fundamental Analysis in a stock market context refers to those underlying factors which
affect the value of a share, and hence its price trend. Macro-fundamentals are the factors
affecting the market as a whole (Joffe, 1995:21-25). Included are the following:
...• Economic factors :-
The gross domestic product (GOP) is the rand value of all final goods and services
produced in the economy for a specific year. The growth in the GOP for the period
1996 and 1997 were 3,1% and 2% respectively and the forecast for 1998 is 2,7%
(Huysamer Stals, 1997:12-14). Historic growth of the South African economy were
erratic at best and through the GEAR program GOP growth has been set at 3% per
annum. The anticipation of a buoyant economy or recession may cause share prices
to rise or conversely to decline.
• Political factors :-
Markets in general dislike political instability and/or uncertainty. The national elections
in South Africa during 1994 caused uncertainty on the Johannesburg Stock Exchange
which caused share prices to move either sideways or downward.
• Monetary factors:-
The relationship between changes in the money supply and security prices has been
the subject of considerable research (Stevenson & Jennings, 1981:137-138).
Although considerable research has been conducted on the relationship between
money supply and security prices, the nature and specification of any relationship is
still not settled. Stock markets generally react positive on declining interest rates
particularly short-term rates. Conversely, markets can react negative if they suspect
rates are heading upwards.
• Industry factors :-
The shareholder, analyst and investor perform industry analysis because they believe
it helps them isolate investment opportunities that have favourable risk-return
characteristics. Consistent performance for specific time periods for different
industries would indicate that industry analysis is not necessary. For example,
assume that during 1998 the total stock market has experienced growth of 15% and
the returns for all industries were between 14% and 16%. If this was the result it
would be questioned whether it is worthwhile to find an industry that would return 16%'
when random selection would provide a return of 15%.
v
.:
Joffe (1995:21-25) says that micro-fundamentals refer to the factors specifically effecting
an individual security or group of securities. Attention towards parameters such as the
earnings of the company concerned, the dividends paid per share, the net asset value,
the debt/equity ratio - in short, all the information which companies normally provide in
their annual and interim reports (financial statements).
1.2. Problem statement
For many shareholders, analysts and investors the critical aspect of an investment
decision lies in the information available with which to make informed decisions on the
value of company securities.
The amount of information available on a company to the shareholder, analyst and
investor is however enormous (Stevenson & Jennings, 1976:53). This put the
shareholder, analyst and. investor before a selection problem as to which information
sources to utilise in the investment decision. The shareholder, analyst and investor wants
to use the relative important investment information as it would lead to an optimal effective
and correct valuation of a company being done.
The criteria that will be used in the selection of relative important investment information
sources are; qualitative characteristics that investment information sources must meet and.the input required from these investment information sources into company valuation
models or tools.
The first criteria of selection that the shareholder, analyst and investor have to go through
is to establish whether a source of investment information represent quality. This is
necessary as sources of investment information of poor quality could actually cloud the
investment decision and lead to poor valuation of companies (Stevenson & Jennings,
1976:53-66). The quality investment information source will enhance the investment
decision ain that an effective decision will be made and the benefit derived from such an
investment information source will be more than the cost involved in using the specific
investment information source (Vorster et aI., 1991 :14-18). The qualitative characteristics
...of all investment information sources, needs to be measured against the parameters of;
understandability, relevance, reliability, comparability and timeliness.
The second criteria of selection that the shareholder, analyst and investor have to go
through is to establish the input required of an investment information source into
company valuation models or tools. This will indicate that a specific investment
information source or a number of investment information sources are important in the
calculation of an "intrinsic value" for a company or business.
To the average shareholder, analyst and investor the annual report which include the
financial statements are the major source of primary information on a public company.
The financial statements contain an income statement, balance sheet, cashflow
statement, notes to the statements, the auditors report and a directors report (Winfield &
Curry, 1981:238-240).
The financial statements provide some basis for understanding the business activities and
the past financial performance of a company. The financial statements indicate to some
extent the breakdown of profitability betWeen different areas (divisions) and the fluctuation
of profits due to such factors as financial gearing (Stevenson & Jennings, 1981). The
financial statements indicate the influence of external factors such as; competition,
technological change and the economy on the company. It is evident that shareholders,
analysts and investors use the financial statements of a company extensively when
valuing companies for investment.
The problem is however, what is the relative importance of financial statements and can
financial statements be regarded as an important information source when it is but one
investment information source among many when valuing companies.
1.3. Study objectives
The primary objective of a shareholder, analyst and investor in the evaluation of a
company is to put a value on the company. This will enable these parties to make
decisions as to whether to buy, retain or sell the shares of the company but also to assist
in the timing of the purchase or sale of the shares (Foster, 1986).
The critical factor determining success in investment according to Warren Buffet is
"determining the intrinsic value of a business and paying a fair or bargain price"
(Hagstrom, 1994:v).
The fundamental approach to investment analysis assumes that each security has an
intrinsic value that can be determined on the basis of fundamentals as; earnings,
dividends, capital structure and growth potential (Foster, 1986:309). The financial
statements of a company also playa major role in determining the value of company when
applying the fundamental approach (Foster, 1986:2).
The primary study objective will focus on the relative importance of financial statements
as an information source in the evaluation process of a company in order to arrive at the
"intrinsic value" of a company. This objective will also take into consideration the other
information sources that needs to be studied.
The following objectives can be formulated for this study;
• Identification of parameters from the financial statements that could assist in
establishing the value of a company.
• Identification of other information sources that needs to be studied in the evaluation of
a company.
This study has as its objectives;
• To establish the relative importance of financial statements in the analysis of a
company for investment purposes.
• To establish what information from the financial statements needs to be studied when
analysing a company.
1.4. Methodology
A literature study will be under taken to establish what other information sources on a
company needs to be evaluated in order to place a realistic value on a company. A
literature study will also be under taken to establish the relative importance of studying
the financial statements of a company in order to place a value on a company. These
literature studies will confirm the relative importance of financial statements in the
valuation of companies for investment.
The literature studies are to be followed by an assessment of what factors will impair the
relative importance of financial statements as an investment information source.
Impairment of the relative importance of financial statements will be shown through
studying currently available financial statements of listed and recently listed companies on
the Johannesburg Stock Exchange (JSE).
1.5. Limitations of study
This study will focus primarily on the fundamental approach for the evaluation of
companies. Therefore the intrinsic value of a company needs to be established and then
it is to be compared with the market value of a company.
It is evident that numerous approaches exist for the evaluation of companies in order to
establish a value for a company. This study will only look at the fundamental valuation
approach and the relative importance of financial statements in this approach and is
therefore limited in that regard.
The study will also not cover all other information sources (besides the financial
statements) that needs to be studied or are available as all information sources represent
collectively a large number. The study is therefore limited in that only the relative
importance of financial statements as an information source in the investment decision will
be established.
I "
. ~ ..In order to establish the relative importance of financial statements the input from the
financial statements into the calculation of value for a company will be evaluated. A
thorough study will be conducted on a few valuation models which obtain their input
mainly from financial statement information. The study will not cover all valuation models
which obtain their input mainly from financial statement information.
This study is also limited in that it will also not focus on all fundamental factors such as
the broad indicators in the economy and a specific industry but merely on those that have
a direct influence on the establishment of value.
The field of investment is also very diverse and dynamic. The investment decision taken
by various participants also differ in regard to investment objectives and requirements of
participants. The term investment in this study relates to equity investment in listed
companies on any recognised stock exchange or investment in unlisted (private)
companies. The study is therefore limited in that only equity investment is considered and
the relative importance of financial statements in this type of investment decision.
1.6. Demarcation of the study
This study will consist of the following chapters and will continue as follows.
Chapter 2 will consist of a literature study on the sources of investment information. The
sources of investment information will be graded against parameters to establish which of
the respective sources of investment information represent quality.
Chapter 3 will consist of a literature study on the financial statements of a company. Key
indicators of value from the financial statements will be outlined which will also establish
the value of financial statements.
Chapter 4 consist of a research methodology. It will establish on what part of the investor
community this research study applies. A report on previous studies conducted on the
value of financial statements in the valuation of companies and the qualification of
financial statements will also be studied.
I I
Chapter 5 will make conclusions as to the relative importance of financial statements in
the evaluation of a company for investment purposes. Recommendations will also be
made in this regard.
IL
CHAPTER 2
LITERATURE ON SOURCES OF INVESTMENT INFORMATION
2.1. Introduction
The amount of investment information available on a company to the shareholder, analyst
and investor is enormous (Stevenson & Jennings, 1976:53). The sources of investment
information could vary from but not limtted to; financial newspapers and periodicals,
security market indices, the reports of companies, investment information services,.
brokerage houses, industry surveys, issuers of securities, economic summaries and
forecasts and software services for computers (Francis, 1976:140-182).
This enormous amount of available investment information put the shareholder, analyst
and investor before the choice as to which of the sources of investment information is to
be utilised. The cost involved in obtaining and utilising investment information may be
prohibitive in that the cost involved could be greater than the added return or reduced risk
achieved if the information were available (Everingham & Kleynhans, 1995:8).
Shareholders, analysts and investors are also usually tied to time constraints when
analysing investment information. The additional cost factors involved with investment
information versus the marginal utility thereof needs to be kept in mind (Stevenson &
Jennings, 1976:53).
The shareholder, analyst and investor also can not ignore available investment
information sources due to the enormous amount and believe that an informed investment
decision will be taken. Although the publication and standardisation of certain information
is governed by legislation, including the Companies Act, companies differ in competence
and integrity (Ogley, 1981:438-489). It may be noted that even with this drive towards
legislation and standardisation of information there are periodical lawsuits, Department of
Justice enquiries into failed companies, or when a chief executive is charged in a criminal
case, time and time again company directors state that they were not aware of the
requirements of the Companies Act and this is their excuse for their own incompetence or
1..1
omissions. This is also evident from the recent number of fraud cases where companies
seemed to be sound due to creative accounting or giving fraudulent statements but were
not sound such as Masterbond (Blake & Salas, 1996:54-55; Hunt, 1997;22-23).
It is therefore evident that although shareholders, analysts and investors face constraints
studying all available investment information sources, the risk is inherent that if too little
information is studied uninformed investment decisions can be taken. This could have
disastrous consequences to a shareholder, analyst and investor.
Due to various constraints facing shareholders, analysts and investors utilising all
available investment information they need to be selective as to which investment
information is to be utilised. One such selection criteria for investment information is the
qualitative characteristics of investment information. The qualitative characteristics of an
investment information source is important in that the quality of an investment information
source influence the effectiveness of the investment decision (Edwards et al., 1989:445;
Vorster et aI., 1992:13-16). Investment information could be measured against
information qualitative characteristics such as but not limited to; understandability,
relevance, reliability, consistency, comparability, conservative, materiality and giving the
user of the information a competitive advantage (Edwards et aI., 1989:442-450).
2.2. Qualitative characteristics of investment information
The users of investment information sources need information to asses the risk, return
and the ability of companies to pay dividends. To do such an assessment on companies,
investment information need to provide information about the financial position,
performance and changes in the financial position of companies (Everingham &
Kleynhans, 1995:5-10).
Vorster (1992:16-20) says for investment information sources to provide such quality
information, investment information sources need to have the following inherent
qualitative characteristics;
• understandability
• relevance
• reliability
• comparability
2.2.1. Understandability
In order for investment information to be of any use to the user of such information, the
average user of such information must have some knowledge on business. The user of
investment information must be able to understand the information when giving the
necessary care when studying the investment informatton (Vorster et aI., 1992:17).
Investment information of a complex nature should not be ignored by shareholders,
analysts and investors merely because it may be too difficult for the users to understand if
it is relevant to the investment decision making process.
It is therefore assumed for shareholders, analysts and shareholders to understand
investment information, they must have;
=> a reasonable knowledge of business and economic activities,
=> a willingness to study the investment information with reasonable diligence.
2.2.2. Relevance
For information to be relevant, it must be pertinent to the investment or bear upon a
decision (Edwards et aI., 1989:447-448). The information must "make a difference" to
someone who does not already have the information. Relevant information is capable of
making a difference in a decision either by affecting user predictions of outcomes of past,
present, or future events or by confirming or correcting expectations.
Actions taken now can only affect future events, and information that posses predictive
value is obviously relevant (Everingham & Kleynhans, 1995:9). This is so as it improves
the users ability to predict outcome of future events.
Information however need not be a prediction to be useful in developing, confirming or
altering expectations. Expectations are commonly based on the present or past (Edwards
.'"
et aI., 1989:447). For instance to predict future earnings of a company one would Iike·ly
start with a review of past and present earnings of the company. Information that merely
confirms prior expectations may be less useful, but is relevant in that it reduces
uncertainty (Everingham & Kleynhans, 1995:9).
Investment information sources that confirm the relative success of users in predicting
future outcomes posses feedback value (Edwards et aI., 1989:447). Information sources
that provide feedback make a difference in decision making due to;
:::::> reducing uncertainty in a situation,
:::::> confirm or deny previous expectations,
:::::> provide a basis for further predictions (Vorster et aI., 1992:18-19).
In order for information to be relevant it must be provided in time to be considered in
reaching a decision. The utility of investment information decreases with time. If
investment information is to be of any value in decision making it must be available before
the investment decision is made. If not, the investment information is useless.
2.2.3. Reliability
In addition to being relevant, investment information must be reliable to be useful
(Edwards et aI., 1989:448). The reliability of investment information depends on its;
:::::> representational faithfulness,
:::::> verifiability,
:::::> completeness,
:::::> neutrality
:::::> and free of bias.
Representational faithfulness is where information gives a reliable representation of the
activities that it purports to represent (Vorster et aI., 1992:18). A road map would be
representational faithful when it shows roads and bridges among other things where roads
and bridges actually exist. There is correspondence between what is shown on the map
and what is physically present.
I •
Verifiability of investment information represent the substantial duplication of information
by independent measures using the same measurement methods (Edwards et aI.,
1989:449). The duplication of information for a financial transactions could usually be
verified by investigating the support documents such as cheques, invoices and credit
notes to reconstruct the actual transaction that took place. Some transactions can not be
physically verified for instance non-cashflow items such as depreciation but can only be
verified by establishing what procedures other accountants would have followed when
allowing for depreciation.
Completeness means that all significant information must be disclosed in a way the
promote understanding and does not mislead with taking into consideration the
constraints of relevance and cost (Vorster et aI., 1992:19). In the financial statements full
disclosure could be made as a collective in the body of the financial statements, the notes
to the financial statements, in other special communications and in the chairman's report
or other management reports.
Neutrality of investment information means that it will not be represented in such a way as
to accomplish a specific end result (Vorster et aI., 1992:18). The primary concern should
be relevance and reliability of the information that results from application of the principle.
Neutral information is needed especially when parties with opposing interest such as
credit seekers and credit grantors rely on the same information. Non neutral information
in designed to favour one set of interested parties over others.
Free of bias is where information are consistently too high or too low due to the
measurement methods employed (Edwards et aI., 1989:448). In accounting bias could
exist as an example in the valuation of stock. Due to the use of the last-in-first-out (UFO)
principle in an inflationary environment stock could be valued to low due to the high priced
items not being part of the stock value as a whole.
2.2.4. Comparability
The qualitative concept of comparability attempts to introduce a common language into
the presentation of investment information about a company for different time periods to
I,
the users of such information (Vorster et aI., 1992:20). Comparability is not however' a
mindless process of standardisation and uniformity.
When comparability exist in investment information, reported differences and similarities
are real and not the result of differing accounting treatment (bias) and non-neutrality
(Edwards et aI., 1989:449-450). Comparable information will reveal relative strengths and
weaknesses in a single company over a period of time and between two or more
companies at the same point in time.
The purpose of comparisons is to detect and explain similarities and differences. To
make comparisons easier the idea of consistency in measurement methods and the
manner of display (presentations) is put forward (Everingham & K1eynhans, 1995:10)..
Without such a requirement the comparability of financial statements and other sources of
investment information would be significantly affected if not destroyed altogether.
2.3. Sources of investment information
The amount of information available to the shareholder, analyst and investor is enormous
(Stevenson &Jennings, 1976:53). For many the critical aspect of an investment decision
lies in the information available and with which investment information sources to utilise to
make a wise and thoughtful trade-off between investment alternatives.
Warren Buffet, the richest man in the United States according to the Forbes magazine in
1993, has obtained his wealth from investment in listed and private companies (Hagstrom,
1994:1-2). Warren Buffet says that to earn superior profits, individuals are required to
carefully evaluate a company's economic fundamentals (Hagstrom, 1994:52). Therefore a
shareholder, analyst and investor problems lie not in obtaining investment information
about a company but in determining which investment information about the company is
useful and then interpreting it.
u.
2.3.1. Market indices
An index is an indicator (Vaughn, 1974:145-156). A market index is an indicator of
activity in some market segment (Huysamer Stals, 1998:8-10). Many Johannesburg Stock
Exchange (JSE) market indices are published, some of which are; all share index (ALSI),
industrial index (INOI), gold index and financial shares index (FINI).
These indices are indicators of different things and, are therefore useful for different
purposes. For example someone, searching for a growth industry would be more
interested in the industrial and financial index than in the gold and all share index. The
gold mining industry is currently not viewed as a growth industry and the all share index
represent the stock market as a whole (Ogley, 1981:439-440). In 1998 the Johannesburg
Stock Exchange gold index has lagged the financial shares index.
Market indices furnish a handy summary of historical price levels in a particular market
segment (Francis, 1976:143-145). This information has several uses;
• Firstly, a person that own shares of a company in a particular market segment or
industry can quickly establish how market movements have affected the value of the
particular company and the market segment.
• Secondly, indices are useful for historical analysis (Sinai, 1995:150-153; Wade,
1995:163-167). By analysing market indices and economic indicators, a shareholder,
analyst and investor can detect some relationships between different market indices
and different economic indicators.
With reference to the quality of market indices as a source of investment information;
• Understandability, the market indices is an understandable source of investment
information as it merely represents a composition of all companies performance in a
specific market segment over specific period of time.
• Relevance, market indices has feedback value as an example it gives information
about past performance of an industry in relation to the market as a whole. A market
indices could also have predictive value as an example.where correlation's between
economic indicators and specific market indices have been found it could be used to
"
forecast future trends for specific market segments on the basis of changes in
economic indicators.
• Reliability, market indices is reliable in that it faithfully represent the trend of a specific
market segment and an indices is also neutral, free from bias.
• Comparability, the market indices is comparable for a specific indices over a period of
time as the information is readily available and is also comparable between market
segments as the different market segment indices are also available.
2.3.2. Brokerage firms research reports
One service that some brokers offer to their clients is research on specific company
securities. Many stockbroking companies have research staff whose function it is to
analyse companies and their shares. The purpose of such research is to identify
undervalued securities that have the potential for price appreciation (Vaughn, 1974:144).
In some cases these findings are published by the stockbroking company such is the case
with stockbroking company, Huysamer Stals. These findings are readily available to the
clients of the stockbroking company (Huysamer Stals, 1998). The cost of these research
reports are usually included in the commission when buying and selling shares.
The stockbroking company's recommendations mostly take the form of "buy", "hold" or
"sell". The word buy means that a shareholder, investor should purchase the shares or
add to current portfolio holdings at the price indicated by the stockbroking company. Sell
indicates the opposite to a buy recommendation. Hold signifies that a shareholder or
investor should not purchase shares but should not sell the shares if already owned. A
hold recommendation therefore must not be viewed as a neutral recommendation.
The individual shareholder and investor should use such research reports in conjunction
with other sources of investment information. It must be remembered that stockbroking
firms and the traders at stockbroking firms profit from the commissions when buying and
selling shares (Mayo, 1980:142).. There is with stockbroking companies a natural bias to
encourage buying and selling of shares as opposed to holding money or placing it in a
savings account.
With reference to the quality of brokerage firms research reports as a source 'of
investment information;
• Understandability, the research reports are understandable and easy to read.
• Relevance, the research reports present relevance in the form of 'inside information'
due to interviews with the management of companies. The research reports could
present feedback (confirmatory) and predictive value but that is a function of the
research capabilities of the stockbroking company. The stockbroking companies is
rated on a yearly basis as to which companies provided and represented the best
research capabilities.
• Reliability, the reliability of the research reports are difficult to asses as one can not
establish whether the report faithfully represent the information it purports to represent
and whether the report is free from bias (neutral) is difficult. Due to the nature of the
above factors one could question the reliability of brokerage firm research reports.
• Comparability, the comparability of research reports are low and comparability is.
mainly in the form of past recommendations and present and future outcomes of such
recommendations.
2.3.3. Newspapers and magazines
The are various financial newspapers in South Africa; Business Day, The Star - Business
Report and Rapport - Sake Rapport to name but a few. These daily and weekly
newspapers publishes not only equity prices but also bond prices, prices of commodities,
treasury securities and foreign currencies (Mayo, 1980:142-145). These financial
newspapers includes news bulletins that are issued by various companies and editorial
comments on the national economy and economic policy (Ogley, 1981 :438-445). The
editorial comments tend to stress those policies that affect the investment community such
as the money supply rate (Wilmot, 1995:167-173).
These newspapers publishes earnings reports of companies and make announcements of
dividends that have been declared (Stevenson & Jennings, 1976:61-64). It also indicates
to shareholders, analysts and investors when is the last day to register for an upcoming
dividend, by owning shares in the particular company.
,.
A variety of magazines also report financial news such as; Financial Mail, Finance Week
and Finansies & Tegniek. The shareholder, analyst and investor that is interested in a
particular industry could read specialised trade journals such as Martin Kramers
Engineering News which covers most developments and happenings in the engineering
industry. Such specialised trade publications will help investors, analysts and investors
keep abreast of events in a particular industry.
With reference to the quality of newspapers and magazines as a source of investment
information;
• Understandability, newspapers and magazines are written to be understood by the
public in general.
• Relevance, newspapers and magazines do have relevance where specific economic
factors that have an influence on the investment community are followed and reported
to the investment community (Wilmot, 1995:167-173). Newspapers and magazines
therefore could have feedback and predictive value where specific factors that have an
influence on the investment community such as money supply and savings rates of the
population at large are reported on (Wade, 1995:163-167).
• Reliability, newspapers and magazines are usually neutral in a democratic society and
play the role of watchdog and protector for the public at large. The reliability of
newspapers and magazines related to the presentation of information to the
investment community is good.
• Comparability, the comparability of information presented on a specific company and
between companies are low due to the nature of reporting on activities in the
investment community.
2.3.4. Annual company report
Companies listed on the Johannesburg Stock Exchange (JSE) are required by law and
stock exchange listing requirements to publish annual and semi-annual company reports.
These listed companies are also required to publish news bulletins giving any pertinent
changes in the company's financial position and any other information that may influence
the value of the company's shares. Companies not listed on the Johannesburg Stock
Exchange (JSE) are required by law to publish annual financial statements.
....
The annual company report is perhaps the most important source of investment
information (Mayo, 1980:138-140). The annual company report includes a substantial
amount of factual and financial information. Companies use the annual report to explain
their achievements of the past year. These discussions are in general terms, but the
company's careful selection of words may allow the shareholder, analyst and investor to
read "between the lines". The more substantive material is presented in the financial
statements especially in the notes to the financial statements. The notes to the financial
statements provide insight into the construction of -the financial statements and the
discovery of creative accounting is mads possible (Blake &Salas, 1996:54-55).
The typical annual report begins with a letter from the chairman of the company to the
shareholders. The letter reviews the highlights of the year and point out certain
noteworthy events such as dividend increases or take-overs that took place (Vaughn,
1974:144-145). The letter may give an indication of immediate expected future events
such as the next years sales growth and earnings. Warren Buffet's company, Berkshire
Hathaway, present yearly very lengthy annual reports. Warren Buffet believes that a
company must be candid with its shareholders and therefore believes in telling both the
good and the bad aspects of the business (Hagstrom, 1994).
The letter from the chairman is usually followed by a general description of the various
components of the business. It may even for example illustrate with words and pictures
the various products and services the company make and sell, the type of research and
development in which the company is engaged, the particular application of the
company's products and services in different market segments and the outlook for the
company's products and services in the different market segments.
The descriptive material on the components of the business is followed by a set of
financial statements. These financial statements are audited and certified on a yearly
basis by accountants (Edwards et aI., 1989). The financial statements include the
balance sheet as at the end of the company's financial year, the income statement for the
financial year and the cashflow statements. A summary might also be given for group
activities when the group consist of a number of operating companies (Ogley, 1981 :438-
441). The financial statements might also include a summary of previous years financial
statements. These summaries permits the shareholder, analyst and investor to view the
company's growth in sales, earnings and dividends as well as the value of the different
classes of fixed and working capital assets.
With reference to the quality of the annual company report as a source of investment
information;
• Understandability, the South African framework follows closely the International
Accounting Standards Committee (IASC) statement on the topic of accounting
standards (Everingham & Kleynhans, 1995:5). It is stated in statement ACOOO that
financial statements are to be understandable.
• Relevance, the financial statements of companies present a lot of feedback
(confirmatory) and predictive value to users in the investment community. This can be
seen in the number of company valuation tools that are used to value a company.
These company valuation tools derive mainly their input from company financial
statements. Some of the company valuation tools that are used include; company
financial ratios, Du Pont analysis, Economic Value Added and the Zulu principle.
• Reliability, the company financial statements represent faithfully transactions and other
events it purports to represent or could reasonably be expected to represent. The
financial statements are usually neutral (free from bias). The company financial
statements are the responsibility of the auditors and directors of the company. There
have been cases where one or both parties responsible for the financial statements
have 'influenced' the financial statements for a particular reason (Blake & Salas,
1996:54-55). The 'influencing' of financial statement by one or both parties will then
obviously lead to financial statements and annual reports to be biased (not neutral).
• Comparability, the financial statements of companies posses the quality of
comparability and which is one aspect that influence shareholders, analysts and
investors to rely a lot on financial statements when valuing a company.
CHAPTER 3
LITERATURE ON THE RELATIVE IMPORTANCE OF FINANCIAL STATEMENTS
3.1. Introduction
-- Different companies have different accounting practises despite the attempts at
- standardisation. Companies may choose among 'several procedures for reporting
expenses, assets or liabilities and these,"alternative" accounting procedures can produce
- vastly different values for expenses, income, return on assets and return on equity..
_ Therefore the shareholder, analyst and investor can have trouble in comparing the
financial statements of two firms in the same industry, much less in different industries
(Winfield & Curry, 1981 :227-261). These different accounting practises is often cited as
one reason for financial statements of companies not to be regarded as of relative
importance when valuing companies.
The standardisation of financial statements is not to important if the latest financial results
are seen as part of a series of financial results beginning five or ten years ago and
stretching for a period into the future. The shareholder, analyst and investor look at how
the latest results fit into the pattern of historical results and how it will impact on future
results. The financial statements performs a role of confirmation of information gathered
and anticipated from other sources of information.
In establishing the value of financial statements in the analysis of companies for
investment it would be prudent to look at valuation models for companies and the input of
financial statements in the various valuation models. Studyinq of these valuation models
vvould indicate the importance that financial statements play in these valuation models.
The relative input of financial statements in the various valuation models would indicate
the relative importance of financial statements in the analysis of companies for investment
and therefore the value of financial statements (Amling & Droms, 1994; Brigham, 1989;
Dobbins et aI., 1996).
A number of valuation models have been developed that attempt to deal with the special
valuation problems posed by common stock. Some of these valuation models will now be
studied as well as the input of financial statements in these valuation models.
3.2. Financial ratios
Financial ratios are but one valuation model used in the performance assessment of
companies (Gardiner & Bagshaw, 1997:30; Helfert, 1987:19). A financial ratio express
the relationship between one quantity and another. While the computation of financial
ratios is simple, the interpretation thereof tends to be far more complex. Ratios are not
absolute criteria but meaningful ratios point out changes in financial and operating
conditions within a company. These changes illustrate patterns of risk or opportunity
when valuing a company.
Financial ratios are based on historical information which is extracted from. the financial
statements of a company (Peterson, 1974:1-9). It is a so that, the valuation of companies,
is simply valuing its future earnings power (Hagstrom, 1994:27-48). A company's value
could be found by estimating the earnings of the company and multiplying those with an
appropriate capitalisation factor or multtplier. This factor is influenced by the company's
stability of earnings, assets, dividend policy and financial health. Valuation of companies
using financial ratios based on financial statements that deals in historical information
may be difficult (Francis, 1988:237-238). Since financial ratios are used by shareholders,
analysts and investors to make projections about the future of a company it is important
for shareholders, analyst and investors to understand the factors that will affect the
financial ratios in the future (Gardiner & Bagshaw, 1997:30; Helfert, 1987:5-65).
The usefulness of financial ratios in the valuation of companies is wholly dependent upon
their skilful application and interpretation.
· 3.2.1. Profitability ratios
The profitability ratios of a company is of key interest to shareholders and investors alike
(Helfert, 1987:5-65).
Shareholders, analysts and investors are interested in the current and long-term
profitability of their investment in a company. Profitability means the returns achieved
through the efforts of management, on the funds invested by the shareholders (Fisher,
1997:40-58). The most common ratio, return on equity, used for measuring the return on
the owners investment is the relationship of net profit after interest and taxes to ordinary
Investment information sources needs to.be subjected to qualitative characteristics before
it can be used as an information source when valuing companies for investment. The.
qualitative characteristics that all proposed investment information sources must be
measured against are; understandability, relevance, reliability, comparability and
timeliness.
Financial statements as an information source meet all the qualitative characteristics
against which all investment information sources should be measured.
5.1.2. Company valuation models and tools
The company valuation models and tools that this study looked at are; Company financial
ratios, Du Pont analysis, Economic Value Added and the Zulu principle. These company
valuation models are currently being used by leading portfolio and asset managers in the
South African asset management industry.
The asset management industry consist of mainly; retail banks, merchant banks, long
term insurance companies, short term insurance companies, pension fund managers of
large corporations and specialised niche asset management operations.
The input required from company financial statements into these company valuation
models and tools are large. The indication from most of these company valuation models
and tools are that more than fifty percent of the input required into these company
valuation models and tools is derived from the companyfinancial statements.
5.1.3. Creative accounting
Creative accounting is where accounting techniques are used within the parameters of
Generally Accepted Accounting Practise (GAAP) to simulate the effects of economic
growth and profit (cash) generation. The simulation of economic growth and profit
generation in the context of creative accounting is rather the result of accounting sleight of
hand.
Creative accounting techniques influence the reliability and comparability qualitative
characteristics of company financial statements. The creative accounting techniques
create a distorted picture of the real and sustainable earnings of a company. This lead to
an incorrect assessment being made of a company and therefore a - too high intrinsic
value - given to a company.
The shareholder, analyst and investor can however counter the creative accounting
techniques. The understanding of these techniques and the influence of these techniques
on parameters in the financial statements needs to be understood by the shareholder,
analyst and investor. Comprehension and understanding of these techniques help the
shareholder, analyst and investor to make the necessary changes to financial statement
information so that the true picture - the correct intrinsic value - about a company is
reflected when valuing the company.
5.1.4. Relative importance of financial statements
Shareholders, analysts and investors use the financial statements extensively when a
company is research for investment purposes. A lot of information can be gathered from
the financial statements of a company. The financial statements of a company is almost a
concise description of the business as a whole. It is up to the shareholder, analyst and
investor to study the financial statements in detail, only then will the volume of information
contained in the financial statements of a company be unlocked to the reader of the
financial statements.
....
It is evident that the financial statements of a company is relative important when valuing
a company for investment purposes. The financial statements is probably the most
important primary source of investment information when valuing a company for
investment.
5.1.5. The role of the human factor in investment
It should be noted that even if one study all available investment information sources, one
should exercise patience and diligence when doing investments.
Warren Buffet says that the shareholder, analyst and investor needs to control his
emotions, which include fear and greed, when making investment decisions. Warren
Buffet goes so far as to say that one needs to develop a certain.ernotional maturity when
investments are made.
5.2. Recommendations
5.2.1. Grading of investment information sources
As there are an enormous number of available investment information sources, it is
recommended that investment information sources are graded on a scale of importance
when valuing companies for investment. This would make the profession of investment
and investment analysis more professional as more scientific and rational processes are
brought to the industry.
5.2.2. Management
Some literature has studied the subject of evaluating management of a company. There
is however still a lot of study that could be done in the valuation of management.
Management is probably also one of the largest determinants of success of a company.
The study of management could provide a basis to detect performing companies prior to
....long track records of success already being established. This would help the
shareholder, analyst and investor to detect early, the winners from a group of companies.
This would obviously assist the shareholder, analyst and investor to earn above average
return on investment.
56
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