Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

Successful equity investing: learn the language

Accounting as a language has worked well for many centuries and has adapted itself quite remarkably to changes in the business landscape

Many want to be very rich. Many believe investing in equity markets will fulfil that wish. Indeed it can. But it is not as easy as it looks. It requires considerable effort. One of the things needed to be a successful investor is to understand accounting, the language used by companies to communicate with their investors. This language does an excellent job of communication but like all languages, it has limitations. Investors need to understand the meaning behind what is being communicated to take better decisions.

In the Gates Foundation’s 2013 Annual Letter, Bill Gates talked about the importance of measurement and how hard it is to get it right. But once achieved, wonderful things do happen. He mentioned innovations that improved the precision in physical measurements thereby helping develop more efficient and less polluting steam engines. Similarly, investors need to know how to accurately measure company performance to be able to invest successfully.

Take the humble price-to-earnings (P-E) ratio. It can be calculated quite easily and has a conceptually sound foundation. Its inverse is commonly used to decide which fixed deposit is more attractive. When interest rates are compared across banks, we are looking for how much we earn (E) for every rupee (P) we invest. Yet, comparing P-E across stocks and buying the cheapest is not necessarily a formula for success. And the reason for that is obvious when one goes deeper into understanding the measure.

The price of the stock is known and, hence, there is no ambiguity there. The earnings, on the other hand, are an accounting concept called ‘profit’, which is what a company earns minus what it spends. So, what can be wrong with that? Well, take a business that exports its produce and receives payment from its customer three months later, and compare it to a restaurant where the customer pays immediately. Even if they make some amount of profit for every rupee of sale, clearly the latter has better economics. Take a hospital as another example. It needs to keep investing in latest technology to offer the best service. It needs to discard the earlier equipment, which is thus rendered obsolete even though its physical life may be longer. Under accounting norms, it can charge depreciation based on physical life or useful life. If it uses physical life, then clearly it is overstating its earnings.

Next, earnings or profits belong to the business and are not usually passed down to the shareholder immediately. Profits move to the shareholder when the business decides to pay dividends (or buys back stock). Factors that determine how much of the profits are shared with shareholders include the time between profits earned and dividends paid, and how the company invests the money in the interim. All these factors go into deciding the P-E of a business and, hence, it is dangerous to make a decision across companies using this ratio alone.

Another important value to look at is book value (B) of the company. This is what the equity holder gets should the company go into liquidation. In the case of banks, as they deal with money alone, they are typically valued on price-to-book (P-B) ratio. Let us take the case of HDFC Bank Ltd. It has a book value of 63,000 crore as of March 2015 under Indian accounting rules. But according to its Securities and Exchange Commission filings in the US, it has a book value of 75,000 crore. How can the same bank have two different book values? Because the rules of language used in India and the US are different. The difference arises primarily because of the way mergers and acquisitions are accounted for. In India, one can use a method called ‘pooling’, while in the US, one needs to use a method called ‘purchase’ accounting. Unless investors understand the ramifications of using one methodology versus the other, they may end up taking a wrong decision.

Accounting as a language has worked well for many centuries and has adapted itself quite remarkably to changes in the business landscape. But there are still nuances that are not quite logical. For example, the concept of not expensing equity stock options given to employees is inexplicable. An employee understands that she is receiving something of value when she is given a stock option. Yet the company refuses to acknowledge the value it is giving the employee as a cost. US accounting rules have been amended to count them as cost. India is yet to implement the same rule.

Another example is accounting of fixed assets. Imagine two companies setting up a similar manufacturing plants with exactly the same costs. The first company borrows money and constructs the plant; the second one uses shareholder capital. The construction takes three years. When the plants are commissioned, the first company will show a higher asset base than the other. This is because the ‘interest’ to be paid to the lender is added to the asset. If the lender has lent money in a foreign currency, which has appreciated in the intervening three years, the asset will be inflated to reflect the local currency depreciation. Therefore, similar assets have different values (in accounting terms) based on the way they were funded even though the assets have the exact same economic characteristics. Quite astounding but completely legitimate accounting entries.

It is not difficult to trace corporate or financial crises globally to some form of misrepresentation of asset values. It was best summed up by a US Federal Reserve official during the last financial crisis when he said this of the balance sheets of banks: “Nothing is right on the right and nothing is left on the left". It’s important to understand the true economic state of a company by learning rules of accounting, for it may not be what it seems.

Huzaifa Husain is head equities, PineBridge Investments India.

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