How relevant are quarterly numbers?

The earnings season every quarter creates a frenzy of activity amongst players in the commercial world ranging from company management, economists, analysts, media to investment bankers etc., trying to predict the outcome of corporate results and its effect on the economy, monetary policies, stock markets, etc.

The predictions of the street normally have a fairly low success rate and in developed economies such as the US, analysts get it right less than 50 per cent of the time. The only prediction that can be accurately made is fewer heart beats for finance professionals in a company and long nights at work during this period!

The fixation with quarterly results by all stakeholders and excessive focus on short-term goals and objectives have unfortunately led to a practice of manufacturing numbers by some companies to shield themselves from the punitive actions of the street, bankers etc., on missing their earnings estimates. Enron, WorldCom,Tyco, Xerox in the US in early 2000s to Satyam in 2009 were in some ways victims of the numbers game.

One of the key drivers for such corporate behaviour is embedded in the hypothesis that missing an earnings estimate causes a disproportionately downward movement of stock prices, while exceeding the earnings target gets a marginal increase in stock prices. This triggers firms to manipulate the earnings in order to exceed the earnings target put out by themselves or by the analysts.

Earnings management

Earnings management, also referred to as the ‘numbers game', creative accounting, window dressing etc., has no standard definition, but is understood and played by many companies, at times using legal means by stretching the interpretations of accounting literature and sometimes using illegal means for managing the books in order to meet a pre-determined target. As Mr Warren Buffet once said, “Managers that always promise to ‘make the numbers' will at some point be tempted to make up the numbers”.

Mr Howard Schilit, accounting professor and author of Financial Shenanigans notes three general reasons why companies use financial shenanigans to cook the books. It pays to do it, it's easy to do, and it's unlikely that you'll get caught.

The game typically starts when a company gives out an earnings guidance or an estimate of the future results to analysts and forecasters, who then predict the value of the share based on such guidance or estimates supplemented by their own research. Normally, the value of a share is a multiple of its earnings over a certain number of years.

As an example, say a 15 price earning multiple (p/e) ratio of a certain share implies that the share is worth 15 times the yearly earnings per share of the company. By following this formula, any decrease in the earnings per share is expected to change the share price with a multiplier of 15. However, in reality, the relationship may not be that linear. As the effect on the share price is expected to be brutal, many companies try to match or beat the predicted numbers by pushing the envelope hard to the borders of legality, and at times even cross over to the other side.

The reasons for managing earnings may range from a constant pressure to meet or beat market expectations/analysts' forecasts in the case of listed companies, reducing tax incidence, to the promises made in the prospectus at the time of an IPO or raising public debt. Other reasons may include meeting the threshold of numbers in loan covenants failing which the lenders could take punitive action or to more mundane matters of managerial compensation or stock options being linked to certain targeted earnings, especially in companies having a dispersed ownership.

Additional risk

In India, we have an additional risk emanating from the fact that a number of principal owners or promoters borrow money for their own purposes against the shares of the companies they manage and own, using these shares as a collateral security. Usually, this security cover is benchmarked to a certain share price and if the shares fall below an agreed limit, then more shares need to be pledged to provide the additional cover. This is what happened when the founders of Satyam used their shares as currency to borrow. The falling stock markets forced them to give out more shares to cover the security cover on the loan. In early 2009, their holding was reduced to much below 10 per cent, an unthinkable proposition for an Indian promoter who owned nearly half the company some years back. Likewise, Enron had the interest on their debts linked to their share prices and that was a trigger for the collapse as their share prices kept tumbling.

(The authors are the founding members of Thought Arbitrage Research Institute.)

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