That's why external auditors are important, but investors have to do their homework too
A new report from the NUS Business School pointed out some interesting differences between institutional investors and retail ones. One of them was the importance placed on different ratios that describe aspects of a stock's performance.
Retail investors said that price/earnings ratio, dividend yield and net profit margin were the key metrics they used to make an investment decision, whereas their more sophisticated counterparts placed more importance on a company's gearing ratio, return on equity and return on invested capital.
Loosely put, retail investors want to buy cheap, collect passive income, and would like to see a company grow revenues while managing costs to keep that dividend coming.
Institutional investors seek companies that are financially stable enough to withstand a liquidity crunch, and they want assurance that earnings growth actually translates to higher earnings per share.
That debt and coverage ratios did not rank higher on retail investors' radar screens suggests that they sometimes fail to consider the downside risks as carefully as the upside potential before deciding whether to invest.
This is partly a result of companies being less explicit about their debt-to-equity or interest coverage ratios as compared to say, dividend yield.
But in uncertain times like these when firms run a greater risk of facing cashflow problems, it is useful to assess a company's ability to pay down its debt obligations.
One rule of thumb from economist Benjamin Graham is that a company should not owe more than it owns. That's satisfied by a net debt-to-equity ratio below one.
Take for example Swiber Holdings. At some point after it last reported earnings in May, it ran out of cash. Looking at the offshore engineering firm's first-quarter financials, you'd see that it reported a net debt-to-equity ratio of 1.57 as at March 31. That's total debt minus cash and cash equivalents to get net debt, divided by total equity. (The definition of total debt is flexible, different analysts define it differently.)
A higher ratio means a higher chance of insolvency, and a net debt level that is 1.57 times of shareholder equity is, well, kind of high.
To be sure, there isn't a clear rule for what constitutes a dangerous level of debt. Optimal capital structure varies by industry so it's worth checking out the ratios of other industry players to get a sense of how aggressive your firm's leverage is.
But one rule of thumb from economist and investor Benjamin Graham is that a company should not owe more than it owns. That's satisfied by a net debt-to-equity ratio below one.
Swiber did say in its annual report that its bank lenders required only that gearing be kept below two, though that hasn't saved it from judicial management. Swiber is not a dividend stock, but even if dividend yield information were available, it would be a limited indicator of growth.
Some companies follow a stated dividend policy and some do not, making it possible for dividends to arise with no clear link to underlying earnings. When that happens, it can be a red flag for poor board governance.
By the same logic, a company that has maintained a steady dividend record for years is often deemed to have a strong management team.
Another useful profitability metric for shareholders is the return on equity (ROE) for a stock, which you can easily get four years of data on from the SGX StockFacts page, under the "financials" tab along with other commonly used ratios.
ROE is basically net income divided by total equity. In the case of Swiber, both ROE and return on capital have been in decline since 2012, with ROE actually falling into negative territory.
In other words, the management was doing a poor job of deploying shareholders' capital, and you would have been better off putting your money elsewhere. What the ROE measure misses is debt, and closer inspection reveals that the high ROEs achieved in the earlier years were fuelled by debt.
But even as investors mull over the different profitability, debt and cashflow metrics, a dose of healthy scepticism towards the numbers is necessary. Numbers, after all, are open to interpretation.
And the newfangled businesses of the digital economy probably make it easier.
As Vanity Fair reported citing sources, even Twitter "kind of fake(s) it" sometimes: "The company sends an e-mail to inactive users who haven't been on the service in a few months, informing them there is a problem with their username or account, which leads people to log in to fix the situation. Magically, those people become monthly active users even if they were not."
You don't get disclosures like that in financial statements. Nor do you get to poke around the day-to-day operations of a company asking questions the way an auditor should. That's why external auditors are so important and why investors polled in the NUS survey also said that auditor independence and engagement mattered to them.
But investors can only hold the board and auditors to a higher standard by doing their homework too. As Senior Minister of State for Law and Finance Indranee Rajah pointed out last month, quality financial reporting is really an ecosystem. Investors need to drive change by asking thoughtful questions to demand better reporting and audit, as well as quality oversight by audit committees.
With more annual general meetings coming up this month, hopefully the flavour of the dialogues goes that way.
A version of this article appeared in the print edition of The Sunday Times on September 04, 2016, with the headline 'Numbers don't give full picture'. Print Edition | Subscribe
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