The Hindu Business Line : Why companies should tell more

WITH stock prices on a relentless upward march there is concern in some quarters about the prevailing valuations. Given the very nature of equity instruments, it is difficult to be forthright in one's views; thus analysts and market commentators who hold a particular view invariably hedge their positions. They are conscious of the fact that what they perceive may well be a partial picture and, quite naturally, would not want to be caught out.

In such a situation, it would help if companies disclose fairly and fully their financial situation, as that may reduce the complexity of equity valuation. But, unfortunately, that is not the case.

The standard of disclosure in India can be assessed at many levels — timeliness, extent and quality of information. On each of these parameters, the quality of disclosure falls short of the desirable.

No doubt much progress has been made since the early 1990s. The volume and quality of disclosures have improved immeasurably since then, but the problems confronting the analysts have hardly been addressed. The lack of standardisation, the delay, the withholding of information and the sub-standard analysis by managements confront analysts and their assessments can be only as good.

Stock exchanges and regulators can, however, do much to improve the environment. Many officials suggest that the framework for disclosures in India is comparable to the best in the world; in many ways, this is true. But it is not enough. There is considerable scope for improvement.

Free cash flows

Take any analyst's report on the state of the market. You would find it is almost solely based on multiples such as price-to-earnings (P/E) or price-to-book-value (P/B). In stock valuation, however, these multiples have little role to play. Most analysts use the discounted cash flow technique to value stocks. This requires information relating to free cash flows (that is, cash flow from operations adjusted for investments in fixed assets, working capital and the level of debt raised by the firm). Such information is, however, available only once a year, and often at considerable lag.

Without timely and regular access to information on free cash flows, opinions tend to be based on multiples such as P/E or P/B. These are, however, only proxies. In an article in the May/June 2005 issue of Financial Analysts Journal, Alfred Rappaport, Professor Emeritus, Kellogg Graduate School of Management, calls an analysis based on earnings irrational compared to the that based on discounted cash flow, which is rational.

As long as the entire market uses these irrational proxies, it is all right. But when at least a section discovers the true level of underlying earnings as depicted by the cash flows, the irrational proxies fail to be proper indicators.

Similarly, companies continue to include non-recurring earnings and earnings from discontinued operations in the profits they disclose. In at least 100 companies in the quarter ended June 2005, profits were higher than that of FY 2005, mainly due to income from sale of assets.

Investment book

Another issue is the market value of investments held by companies. For instance, the market value of investments held by such companies as ICICI Bank, IDBI, IFCI, Tata Investment Corporation and a number of banks and non-banking finance companies is vital in putting value to their stocks. This information, too, is available only once a year.

In this context, why should investors make do with estimates relating to historical periods with respect to cash flows and market value of investment portfolio? Analysts have to estimate future values. Will a market that estimates values base on past performance ever be efficient?

It cannot be argued that providing information on cash flow and company's investment is time-consuming. These data are necessary to value stocks accurately. They must be disclosed at least every six months. If we want to move towards an efficient market, there can be no compromises on this score.

Industry-related information

Besides cash flow and market value of investments, there is other industry-specific information crucial in estimating cash flows. For instance, in banks, information on yields, margins and bad loans is essential.

Similarly, for software companies, billing rates, number of employees hired, proportion of fixed-price/time and materials, proportion of offshore and on-site operations, and so on, comprise essential information. Many companies in this sector, however, do not disclose such vital information every quarter.

For instance, public sector banks disclose gross and net non-performing assets every quarter. But private sector banks do not. Almost all public sector banks disclose information relating to net interest margin (the difference between the rate at which funds are borrowed and lent). Barring a few, most private sector banks do not.

Similar disparities in the quality and level of disclosures exist in other major industries, such as IT, healthcare and consumer goods.

Some managements expound on such vital pieces of information in `conference calls' with analysts. But many do not do. This divergence in disclosure leads to asymmetric information availability, a state where one set of market participants is privy to price-sensitive information. This can encourage insider trading.

No uniformity

There is also an alarming lack of standardisation in segment information. For instance, HDFC Bank discloses information on wholesale banking, retail banking and treasury. In contrast, Canara Bank discloses information on treasury and banking operations. Banks approach to measure asset allocation to various segments also varies.

Infosys discloses information on various verticals while Satyam does not disclose segment-wise information. Thus, management discretion is often used to reduce the value of information disclosed. The utility of segment information, in particular, has been eroded considerably.

In the case of annual results, Reliance Industries discloses the free cash flows generated by each segment. Few big companies disclose free cash flows of each and every segment. In diversified companies such as ITC, Indian Rayon, Grasim, Tata Motors and Wipro, disclosure of free cash flows, segment-wise, is vital.

The regulator has to ensure that some guideline is mandated to ensure that vital industry-specific information is disclosed within a specific period and in the proper format. For instance, steel and cement companies should disclose production and sales data within 15 days from the end of a quarter. Similarly, banks should disclose advances and deposits growth within 15 days from the end of quarter. Accounting standards for segment reports and segment-wise cash flow information need to be tightened so as to leave managements with less discretion on how to disclose them.

Non-disclosures that hurt

When Gokaldas Exports came out with its public offer it was accorded premium valuations that only industry leaders command. The standard it set subsequently in terms of disclosure, however, left a lot to be desired. Its financial performance report for the quarter ended June 2005 did not disclose the performance in the corresponding previous quarter.

It was disturbing to see Gokaldas Exports indicate that "since this is the first year of listing, figures for the corresponding earlier quarter have not been given". The company did not say it did not have the required numbers. It chose not to disclose.

In a similar vein, many companies that came out with public or rights offers in April or May did not disclose the financial performance for the quarter ended March 2005.

For instance, Oriental Bank of Commerce that came out with its public offer did not disclose its financial results for the last quarter of FY 2005.

The results were particularly vital as they would reveal how the bank dealt with the losses arising from its merger with Global Trust Bank. Needless to say, such non-disclosure only hampers proper stock valuation.

Strong regulator

It is now quite clear that unless the regulator pushes and prods the listed companies, improvement in the quality of disclosures, standardisation and timeliness are unlikely to materialise. Such improvements are not merely desirable, they are essential features, without which the stock market cannot function efficiently.

The poor disclosures may also explain partly the obsession of analysts with quarterly financial performance, frequent revision of price targets and even their views on a particular stock. If these ills are to be addressed, regulatory intervention is needed, and early.

Prompt regulatory action against offenders, regular surveys on how disclosures meaningfully further the cause of stock valuation and revisiting the framework for disclosures are essential to creating a truly fair market for stocks.

Else, irrational price swings, asymmetric information and rampant insider trading will characterise the stock market, and muddy its role as an efficient allocator of scarce capital.

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