Prospective analysis

Here's a link (on SSRN) to a chapter on Forecasting from IGNACIO VELEZ-PAREJA (Universidad Tecnologica de Bolivar School of Business) and JOSEPH THAM (Duke University - Duke Center for International Development in the Sanford Institute of Public Policy; Duke University - Center for Health Policy, Law and Management). From the abstract of the paper:

We discuss some ideas useful when forecasting financial statements that are based on
historical data.
The chapter is organized as follows: First we discuss the relevance of prospective analysis for non traded firms. In a second section we a basic reviews of subjects that will be needed for forecasting financial statements. We discuss the use of plugs for financial forecasting. We show an alternate approach to avoid such popular practice. The approach we propose follows the Double Entry Principle. This principle guarantees consistent and error free financial statements. We show with a simple example how the plug works and its limitations and problems that arise when using it.

Next, the reader will find what information is needed for the forecasting of financial statements and where and how to find it. We present the procedure to identify policies that govern the ongoing of a firm such as accounts receivable and payable, inventories, dividend payout, and identify price increases and other basic variables. We also deal with the real life problem of a firm with multiple products and/or services. We start with historical financial statements We include inflation rates, real increases in prices and volume and policies in order to construct intermediate tables that make very easy the construction of the pro forma financial statements. We use a detailed example to illustrate the method.
We derive the cash flows that will be used in the book to value a firm. This type of
models might be used by non traded firm for a permanent assessment of the value creation. Finally we show some tools to perform sensitivity analysis for financial management and analysis.

Accounting jobs

Looks like it's still a good time to be studying accounting. The latest research from the Dept of Education, Science and Training suggests that there will be an ongoing shortfall in accounting graduates. Keep studying!

Qantas

Just a bit more on the Qantas private equity bid. Given the recent profit upgrades, any shareholders who did sell out on the advice of the Qantas board have the right to feel aggrieved. Perhaps legally so. I wouldn't be surprised to see a class action commenced over this. John Durie comments here.

EPS targets

EPS (Earnings per share) is a commonly cited performance measure. Trouble is, it doesn't tell us that much. Recently, CSL Ltd effectively tripled its earnings per share by undertaking a 3 for 1 share split. Nothing about the future performance (cash flow or overall earnings) changed. Paul Kerin points out how managers focused on increasing EPS can do two bad things: (1) undertake investments when they shouldn't, and (2) not undertake investments when they should. So, what's a better measure? Kerin argues that we should focus on "cash and strategic logic". If you're looking for an overall performance measure, then Return on Equity (ROE) or Return on Assets (ROA) are going to be better than EPS, or EPS growth.

BHP / RIO

There will be masses of words written about this. The whole process is going to take some time. Here's a starting point: Bryan Frith.

Earnings quality / pro forma earnings

Here's an oldie but a goodie. Businessweek from 2001.
Key graphs:

Sometimes, as in the case of Enron, fuzzy numbers result from questionable decisions in figuring net earnings. More often, though, the earnings chaos results from a disturbing trend among companies to calculate profits in their own idiosyncratic ways--and an increasing willingness among investors and analysts to accept those nonstandard tallies, which appear under a variety of names, from "pro forma" to "core." (Enron offers its own such version. Before investors untangled the importance of Enron's first announcement, its stock rose briefly because it told investors that its "recurring net income" had met expectations.) The resulting murk makes it difficult to answer the most basic question in investing: What did my company earn?

Why calculate a second set of earnings in the first place? Because the numbers reached by applying generally accepted accounting principles (GAAP) are woefully inadequate when it comes to giving investors a good sense of a company's prospects. Many institutional investors, most Wall Street analysts, and even many accountants say GAAP is irrelevant. "I don't know anyone who uses GAAP net income anymore for anything," says Lehman Brothers Inc. accounting expert Robert Willens. The problem is that GAAP includes a lot of noncash charges and one-time expenses. While investors need to be aware of those charges, they also need a number that pertains solely to the performance of ongoing operations.

That's what operating earnings are supposed to do. But because they're calculated in an ad hoc manner, with each company free to use its own rules, comparisons between companies have become meaningless. "No investor--certainly not any ordinary investor--can read these in a way that's useful," says Harvey L. Pitt, chairman of the Securities & Exchange Commission. The SEC is examining whether new rules are needed to clarify financial reports and perhaps restrict use of pro formas.

What's badly needed is a set of rules for calculating operating earnings and a requirement to make clear how they relate to net income. In the end, investors need two numbers--a standardized operating number and an audited net-income number--and a clear explanation of how to get from one to the other.

Excessive pay deal?

John Durie on the back page of The Oz puts forward a suggestion: if the Telstra board ignores the vote against the proposed executive pay package (see SMH discussion here, then the logical step is to vote out the board. Heh. Let's see if the government (or the Future Fund) are prepared to do that!

Sub-prime stupidity

Dennis Berman in the Wall Street Journal calls it like it is.

The subprime realm has thus become a vital portal onto Wall Street, helping us understand just how upside-down the place has become. In this world, risk management is applied retroactively. CEO succession planning is, too.

Don't let those on Wall Street fool you by saying "this is the natural cycle of things." Does it really have to be? Unlike virtually any other industry, Wall Street shakes, twists, and hammers on its innovations until they break. What would happen if Boeing Co. or Johnson & Johnson rolled out products with similar defect rates?

Credit rating agencies / subprime / Citigroup

Still more on credit ratings. Turns out the mathematical models used by banks such as Citigroup to value securities like the securitized (sic) subprime mortgages (CDOs, or collateralised debt obligations) relies heavily on credit ratings. That led to the situation where (as we've discussed in class) a downgrade by a ratings agency becomes somewhat self-fulfilling. Wall Street Journal "Heard on the Street" article (via the Oz) here . [Note: this is one of the early benefits of News Corp buying Dow Jones. The Australian gets access to the Wall Street Journal. Goodbye AFR?

Pressure on security analysts

Do analysts ever wonder about the consequences of downgrading their recommendation on a firm? What if it's death threats? Yep. I think the analyst made the right call. As long as they're not, you know, actually killed.