COMMENT/Donal O'Connor: Do investors care only about the financial numbers? Are they short-termists with models based upon the latest quarterly report?
Results from a recent experiment conducted by PricewaterhouseCoopers and Schroders, a major fund manager, suggest this traditional portrayal of the investment process is far from accurate.
Indeed, it appears that, although the models generated by investors may be geared towards exposing the future earnings potential of any given company, the confidence they have in this forecast - and thus the value they place upon the stock today - is based upon a far richer set of data than merely financial.
To explore this idea, PricewaterhouseCoopers approached Coloplast, a Danish company recognised as a leading company in its presentation of total corporate - not just financial - performance.
Whereas most companies supplement their financial reports with a simple statement of strategic intent backed up with a few, well-chosen metrics to illustrate performance, Coloplast goes that extra mile, identifying - and where possible, quantifying - all the key activities that need to come together within the firm to implement its strategy and then linking these activities to its expected financial outcome.
The information set presented is impressive indeed, far outstripping anything that regulatory reporting models require.
But does this corporate transparency make any substantive difference to the information user? Is Coloplast rewarded for its effort?
A PricewaterhouseCoopers corporate reporting specialist dissected Coloplast's 2001-2002 annual report and accounts.
Through careful editing, a new abridged version of the document was generated that omitted all of the quantified, non-financial data that Coloplast elects to report.
The result - a document that was compliant with accounting standards, that included the narrative typically provided in the front end of the report and accounts, but that deliberately excluded the supporting metrics that relate Coloplast's operational performance to economic outcomes.
So armed with two versions of Coloplast's report and accounts - the extensive original document and the financially compliant document - the PricewaterhouseCoopers team descended upon the offices of Schroders.
Each member of the Schroders investment team was presented with one of the two versions of the report and asked to use the information provided to develop a forecast of revenue and earnings for the next two years, to provide a recommendation for the stock and to support that recommendation with their key reasons.
They had two hours to complete their task - no conferring or external information sources allowed.
The findings were quite startling. The average revenue and earnings forecast by those with the full extensive set of accounts was lower than those who had just the financially-based document.
This might be a little discouraging for advocates of greater transparency if it were not for the fact that, despite the lower forecast, the group with the complete information set were overwhelmingly in favour of buying the stock. This stands in stark contrast to those with the less complete information set. Although the average estimate generated was higher, nearly 80 per cent of this group recommended selling the stock.
This outcome may be understood through a closer examination of the earnings estimates generated. The degree of consensus surrounding the forecasts generated by the two groups varied greatly.
Those with the full set of supporting non-financial measures, with the more complete picture of corporate performance, generated a much tighter range of estimates than those restricted to using just the financial performance.
In other words, there was a degree of consensus on the forecasts among those members of the group with the extensive information.
From this one may conclude that those with the full information set were more confident in their forecasts - the result: a higher valuation for the stock - hence the propensity towards "buy" recommendations.
Similarly, when presented with just financial information, uncertainty in the economic projections for the company increased and so the value of the firm today came into question - the result: a resounding decision to "sell".
We can assume, therefore, that although investors' analytical models may be financially driven, the factors that allow analysts to gain confidence in their models of revenue growth, margin trends etcetera are typically non-financial in nature.
Revenue rises because a company is in a growing market and/or is gaining share. Market share increases through new product innovation, through superior customer recruitment and retention policies, and so on. Companies failing to make this visible in a credible and well-structured fashion cannot be surprised if investors assume the worst when placing a value on their estimates of future financial performance.
Does all this drive management to an inevitable increase in the volume of the information that they present? Not necessarily.
Work that PricewaterhouseCoopers has done for a number clients suggests, as in many things in life, it is quality and not quantity of information that will generate rewards in the capital markets.
Similarly, this work reveals the magnitude of the economic benefits that can accrue to firms that offer a more comprehensive picture of corporate performance.
In short, there is a competition for capital out there and every firm needs to question whether its corporate reporting is positioning it for success in attracting such capital.
Donal O'Connor is senior partner with PricewaterhouseCoopers
