Gushing Black Ink on Income Statements

If there is one lesson of the current financial crisis, it is that strong balance sheets and income statements no longer tell investors enough about the performance of a company, whether it be a bank, a service or a product company.

Over the last few decades, technology has fueled a burst of knowledge creation that has allowed companies and economies all over the world to create greater and greater results using fewer and fewer physical inputs. Computers have made us smarter and more efficient. This has led to a problem in corporate valuation. Until this boom happened, the market value of the average company was close to its tangible book value. That is, most companies were worth the sum of their assets.

This made life easy for the equity analyst. Evaluation of future earnings potential could be tempered by and compared with the book value of the company. That is no longer the case. Today, the book value of a company’s tangible assets (as seen on the balance sheet) only explain 20% of its value. That means that the analysis of earnings potential has become more and more important.

Analysts today read between the lines of an annual report, ask as many questions as they can and, ultimately, make a call on the earnings potential of a business. It’s useless to check against the balance sheet. But this creates a problem. Income statements describe the past performance of a company. When companies were tangibles-based, the balance sheet described the future performance potential of a company. If a company owned a plant capable of producing 10,000 automobiles per month, past earnings could be used more confidently to project future earnings.

But what happens when there is no balance sheet? The analyst can see past earnings. But how can he or she judge the future performance potential of the company? It’s kind of like buying an oil well because oil is gushing out of the ground.

Would you buy this oil well without getting geology reports that showed the potential of the well, the expected amount of oil under the ground? I know you are probably laughing to yourself. Of course not, you say, I would never be that naive.

But that’s what you do when you buy stock in an intangibles-intensive business. You are buying based on the income statement, not the balance sheet. This holds true for financial companies too. Yes, I know that they have the value of most of their investments on their balance sheet. But, as we have seen, that value can change. More important is the intangible information about the quality of the assets and the quality of the process that monitors quality and risk.

Now, a lot of people have grown accustomed to this situation. They don’t think they need information about intangibles. (I have a theory that this is because they are sick of seeing intangibles thrown on a balance sheet after an acquisition–but that’s a topic for another day). But the current credit crisis shows that they are dead wrong.

Financial statements gave little or no indication of the looming problems of the credit crisis. The earnings were flowing throughout the system. CEO’s and investment bankers were earning historic bonuses based on these historic earnings. They were, after all, doing what everyone expected them to do: drive earnings in order to increase shareholder value.

This habit of using earnings as the primary indicator of successful management led many down the wrong path. They didn’t ask questions about the drivers of future earnings. How were the investments in mortgage-backed securities valued? What was happening to home values and mortgage defaults? How strong were the processes within financial companies for monitoring credit quality and risk analysis? Who was auditing the processes, because (as I discussed last week) the regulators were not doing it.

Gushing black ink is good for short term value. It tells you very little about the future of a company. For that you need both a tangible and an intangible balance sheet.