Measuring and Valuing Corporate Performance

While the FTSE-100 may have lost 40% of its value over the last two years, 40% of the companies that make up the FTSE-100 have seen their shares hold steady or improve.

As KPMG corporate finance partner Michael Higgins observes, “Generalising about sectors just doesn’t work. You have to look at the detail – there are always companies in each sector who are outperforming their competitors.” Similarly, relying on market stereotypes of sectors is also misleading.

The telecoms sector is widely held to be dead in the water. But he points out that if one takes the performance of the FTSE-100 as a measure, for the three months ending December 2002, telecoms stocks outperformed the FTSE-100 index. “It wasn’t a huge upward surge, but at least it was on the right side of the FTSE,” he notes.

“The sector has taken a massive hit and has had a tremendous shake-out. What we now have is a small number of dominant, highly leveraged incumbents across Europe. But, these players have cash flows that are strong enough to get them out of their highly leveraged situations. Against them we have new entrants who have managed to survive, and they all tend to have adequate funds to pursue their business models. If you are analysing a sector like this, you would expect to see a period of relative stability for the next 12 months, with potentially a secondary crisis one or two years away, as some of the business models fail to generate the anticipated cash returns.”

Higgins argues that if one looks at valuations based on measures such as EBITDA, these are now generally back to pre-bubble levels, matching the figures for 1998 and 1999. This suggests that some much-needed air has been let out of the market and we could be back on a sounder footing.

“For me, the best predictor of performance at the moment, across all industry sectors, is free cash flow. A company’s cash-generative capability is what drives things forward. The thing to concentrate on, when looking at company accounts, is traditional profit and the extent to which the company is capable of converting profit into cash,” Higgins comments.

Steve Russell, strategic analyst at HSBC, agrees. “The market has now really gone back to basics. It is now all about cash flow, the ability to pay down debt and the nature of dividend yields,” he argues. Russell points out that UK plc has done rather well over the last two years as far as paying down debt is concerned; the focus has shifted to dividend yields, where the story is rather more woeful.

“Dividend yields today are practically the same as gilt yields, at around 3.9%, which suggests either that people expect further significant falls in the markets, or that future growth will be practically non-existent.

In our view the markets are overly pessimistic at the moment and it is very difficult to see what is going to change that in the short term,” he says.

It really does not seem to matter how well particular companies do. As Russell observes, “We have had very little by way of bad news in corporate announcements in the UK in recent months and the market is still just not interested. Fund managers with cash to spend are either still pouring it into the bond market or are letting it pile up while they wait to see how things develop.”

According to Russell, in the current market conditions, a metric such as p/e ratios does not indicate much. “The problem with p/e ratios is that the market simply does not know what to compare them with. The 1990s are no longer relevant. Ratios now are lower than they have been for 30 or 40 years. You have to go back to the 1970s to find so many single figure p/e ratios. Dividend yields are a much more meaningful metric right now,” he suggests.

David Nesbit, Ernst & Young regional managing partner for Scotland and Northern Ireland reckons that the signs to watch for are simply a robust balance sheet and solid cash flow. However, he argues that this is a time when anyone interested in a company has to go beyond the figures to make a judgement. “It may well be, if you are looking at a weak set of figures, that what you are seeing is a management team that has taken all the brave decisions, taken present pain, and has got the company into much better shape to prosper going forward. If you are looking at dividend yield, then you need to work hard to understand the cash flow, so that you can understand why the yield is as it is, particularly if it is surprisingly high,” he argues.

He says there are surprisingly few Brownie points for simply meeting analysts’ forecasts. “The market swallows that and moves on. What the market really wants to know about is the long-term growth story and how credible is it? What is your potential for an upturn? This is far more important than your last earnings figure, whatever it might have been!”

PLANNING FOR THE FUTURE

“Make sure you have contingency plans in place. Take a hard look at costs. The outlook is much more uncertain than usual.” These hard-headed words from Doug Godden, head of economic analysis at the CBI, ought to reflect what FDs are currently doing already: taking an analytical approach to their cost base so as they can act quickly if things worsen – and be in an even stronger position if things (hold your breath) start to improve.

But Mike Sherratt, chief executive of Armstrong Laing Group isn’t so sure. As head of the performance optimisation software company, he believes that too many FDs are still looking backward at their costs and, without adequate activity-based cost data, simply don’t have the right information to make sensible strategic decisions.

He believes that too much effort is being put in to shortening the reporting cycle – but that’s not really much use to line managers who still get nothing except historic data, albeit a few days sooner.

Neither does David Norris, a director at consultancy Collinson Grant, believe that companies have the right cost information readily to hand.

“There’s been a great rush over the last five to ten years to put in enterprise resource planning systems – but when you ask if it has helped decision-making, very often you find the answer is no,” Norris says. (The latest findings from the Hackett Group reveals that, on average, companies have almost three ERP systems – which can’t help much.) Some of the problems are organisational complexity and a proliferation of product lines, increasing costs and squeezing margins, Norris adds: “The notion of absorption costs based on direct labour is just not appropriate any more. You’ve got to look at individual drivers. In many ways, management of overheads is now the main issue.”

– Andrew Sawers.