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Can Investors and Employees Foresee Their Company’s Future?
by Marty Daks
May 20, 2008
Runaway energy
costs, a collapsing housing market and a credit squeeze are continuing to hammer the U.S. economy,
giving businesses and individuals alike a severe case of the jitters. As large publicly held icons
like Bear, Stearns & Co. Inc. implode and layoffs rise – 80,000 jobs were eliminated in March –
notching up the national unemployment rate by three-tenths of a percentage point to 5.1 percent,
according to the U.S. federal Bureau of Labor Statistics-consumer confidence is falling, and
employees and investors alike are scouring the landscape for clues to the future of the companies
that they work for or invest in.
Other than tapping into Warren Buffet's brain, there appears to be no foolproof way to
forecast a firm's future. But individuals who pay close attention to trends and to publicly
available information like company reports may be better able to gauge the health of a business,
say experts at Emory University and its Goizueta Business School.
Uncertainty Breeds Concern
There may be plenty of uncertainty, but timely information may provide a degree of guidance,
note faculty members. Part of the challenge however, lies in sorting good information from bad
information.
"Rumors about individual companies are always circulating, and the Internet gives them a
platform for wider and faster dispersal," says William J. Carney, a professor of corporate law at
Emory's School of Law. "For that matter, many blogs have sprung up that comment on particular
stocks. But there's always some question about the degree to which rumor mongers or bloggers may be
engaging in self-serving activity in an attempt to move a stock's price in a particular direction."
Some people rely on professional analysts or ratings agencies to update them on a company's
prospects, he adds.
"But even respected agencies like Standard & Poor's and Moody's Investors Service appear
to have been caught flat-footed in the subprime mortgage collapse," says Carney. "Given the recent
events, some investors and others may no longer feel so sure of the agencies anymore."
Wellsprings of Information
There is some good news for investors and employees, however.
"Under the U.S. regulatory framework, publicly held companies are required to file extensive
disclosure documents on a regular basis," adds Carney. "Every quarter a listed company, or firm
that trades on the New York and other stock exchanges, must file a 10-Q that details balance sheet,
income statement and cash-flow activity and other information."
On an annual basis listed companies are required to file form 10-K that also contains
informative data, including management's analysis of the firm's market. Finally, any time anything
significant occurs, companies are required to file a form 8-K within a few days detailing the
unusual activity.
Even with these precautionary tools, Carney notes, a close analysis of disclosure reports is
no guarantee of future performance.
"For one thing, the quarterly and annual reports are somewhat dated," he says. "They're not
conveying real-time information, like the kind that management has, but are instead looking back to
a period that has already ended. Another is the fact that there is always the chance of an
unpleasant surprise that can't be anticipated or inferred from the financial statements and
disclosures."
One textbook example is the September 11, 2001 terrorist attacks and their effect on the U.S.
economy.
"A recent example of unexpected activity is the utter collapse of certain [exotic] financial
markets that decimated Bear Stearns," says Carney. "We've seen companies with risky pools of assets
before but not to this extent. In this case the whole market collapsed. Events like this are so
infrequent however, that it can be difficult to assign a probability to their occurrence."
There are additional challenges, says Al Hartgraves, a professor of accounting at Goizueta
Business School.
"Accounting standards require publicly held companies to report their financial performance
and position at specific dates, such as each quarter and at the end of the year, but by the time
the reports are issued the information is more than a month old," he explains, noting a concern
similar to the one expressed by Carney at Emory's School of Law. "So someone reading the statements
is looking at historical information, not contemporaneous information."
Further, significant issues can slip through the cracks even if the financial statements are
prepared in compliance with generally accepted accounting principles (GAAP) and are audited in
compliance with generally accepted auditing standards.
"Accounting standards require the write down and loss recognition of
other-than-temporarily-impaired assets, so in theory investors and other users of financial
statements could have been alerted in advance to the meltdown of subprime mortgages," says
Hartgraves, referring to the collapse of Bear Stearns. "But there are two issues here. The first is
that an impairment review is really a judgment call, where management and the auditors were trying
to determine the probability of being able ultimately to convert assets into cash. Further, the
determination was being made as of the balance sheet date, and at that point management and the
auditors may not have deemed the underlying securities to be impaired."
Companies are required to include or disclose in the financials certain subsequent events
that occur between the reporting date and the date of issuance of the financial statements, notes
Hartgraves.
"But events involving the continuing deterioration of asset values, such as declining values
of receivables and investments, generally are not subject to this requirement," he says.
Some remedy to this may be forthcoming, as the U.S. accounting profession moves closer to
fully adopting so-called fair-value or current-value accounting standards-in contrast to GAAP's
traditional reliance on historical cost-as part of a broader convergence between U.S. GAAP and
international accounting standards.
"But it's still a fuzzy concept," suggests Hartgraves. "Fair value accounting is based on
estimated future cash flows, and the mathematical models involve a lot of subjective judgments."
He suggests that investors and employees alike "keep your ear to the ground. When you hear
rumblings in trade publications, the media, the Internet or elsewhere, start asking questions to
see if your investments, especially those in your 401K, are vulnerable. Then sit down and decide if
you need to chart a new course of action. And most of all, always maintain a healthy
diversification in your portfolio as insurance against a catastrophe."
Analytical Tools May Help
In some cases, analytical tools and certain trends may provide an early warning about a
company's financial health, points out Gregory Waymire, an accounting professor at Goizueta.
"Declining revenues over several periods may be cause for concern," says Waymire,
"particularly if the declines are associated with reduced receivables turnover. This can indicate a
company's customers are having trouble paying their bills."
A decline in a company's interest coverage-or a ratio that compares earnings before interest
and taxes to total interest-may also signal weakness, he says.
That's because a company that maintains earnings significantly higher than its interest
requirements may be in a better position to sustain short-term financial problems, notes Waymire.
In contrast, a company that can barely cover its interest costs may easily fall into
bankruptcy, even if its earnings suffer for a single month.
"For public companies, a declining stock price that doesn't seem to be capable of a rebound
may be cause for concern," Waymire adds. "Privately held companies, of course, won't have a
publicly disclosed stock price, but employees who have access to the financial statements may be
able to use the aforementioned metrics to get a good idea of the firm's direction and health."
Given the vital role that businesses play in the lives of employees and investors, it's not
surprising that a significant amount of academic literature has focused on the early detection of
corporate strengths and weaknesses, notes Peter Demerjian, an assistant professor of accounting at
Goizueta.
"One popular measure, developed by Edward Altman of New York University, is called the
Z-Score," he says. "The Z-Score uses financial statement ratios (such as return on assets, sales
turnover, working capital ratio) to predict bankruptcy."
Firms with scores greater than three are considered to have a low risk for bankruptcy, while
lower scores are associated with an increased risk of trouble.
"Another model of bankruptcy prediction, developed by Tyler Shumway of the University of
Michigan, uses both financial statement and market data-including stock returns and stock
volatility-to assess a company's likelihood of going bankrupt," notes Demerjian.
He adds that a third model, called the Merton/KMV model that was developed by Robert Merton
of Harvard University, compares the assets and liabilities of a firm and measures how far the
firm's assets would need to fall for bankruptcy to occur.
"The Merton/KMV model is similar to the Black and Scholes model used to price stock options,
and calculates a company's "distance to default," explains Demerjian. "While each of these measures
has proponents and detractors, each is commonly used in practice."
Academics have also tackled accounting fraud, which crippled large companies like Enron Corp.
and WorldCom Inc.
"Daniel Beneish of Indiana University created a model to predict accounting fraud using a
variety of financial statement variables, including depreciation rate, gross margin, and leverage,"
says Demerjian. "The Beneish model predicted several major frauds, including WorldCom Inc. A
related model examines other variables that may predict fraud, including market variables."
A significant increase in accounts receivable as a percentage of sales may also be an early
indicator of financial stress, according to Demerjian.
"Consider a firm that sells a product to a customer on December 30, 2008 and agrees to
receive payment on January 3, 2009," he says. "At the end of 2008, the seller no longer has the
product in its inventory; and they also have not collected the cash. Under accrual accounting, the
company can still recognize the sale in 2008, and it also books asset, called an account
receivable, in lieu of the cash."
But what if the buyer never pays the seller company?
"It follows that firms with high levels of receivables or high growth in the levels of its
receivables may hold more risk than firms with lower levels or slower growth of receivables,"
explains Demerjian. "An academic study by Richard Sloan of Barclays Global Investors (written when
he was at the University of Pennsylvania) shows that firms with high receivable-accruals have poor
stock returns in the future."
Other studies arrive at similar conclusions, adds Demerjian.
While it is often easier to track down information for publicly held companies, since they
are required to issue financial statements on a periodic basis, inquisitive employees may be able
to obtain information about a privately held firm that employs them.
"If your employer is cutting back long-term investment projects, which conserves capital in
the short run but may harm long-term prospects, it could be a signal of impending difficulty," says
Demerjian. "Another signal is if your employer tries to boost sales by offering products at deep
discounts, particularly if the company is a retail operation."
Firms that suddenly cut more slack on their credit terms may also be starting to sink, he
notes.
"A stable, profitable business will have set parameters for credit terms," says Demerjian.
"But a firm that needs a short-term sales boost may start to offer more generous credit terms, or
may relax its credit standards and extend credit to riskier buyers. Over the long term this can be
very costly since the likelihood of nonpayment is likely to increase proportionately. At the
extreme, this is like recognizing a sale for which the company never expects to get paid."
Another Way of Viewing the Issues
Some faculty suggest that the issue should perhaps be recast from predicting a company's
prospects to instead focusing on the match between risk and reward.
"By now investors and employees alike should recognize that certain companies and even some
industries are prone to volatile cycles," says Ray Hill, an adjunct senior lecturer of finance at
Goizueta. "Timing is important, as we saw in the late 1980s when Wall Street firms like E.F Hutton
and Drexel Burnham Lambert ran into problems. So at a time of financial distress, it may not be
surprising that an institution like Bear Stearns could go under."
In some ways the illusion of well-being can be compared to seeing a person get out of an
expensive car carrying a thick roll of cash, adds Hill. An observer may think the individual is
wealthy, but to be certain they would have to focus on deeper issues."
"Individuals and institutions hope to be rewarded for taking on risk," he says. "For an
employee, the choice may involve working for a relatively stable business like a utility company.
You'll likely have a job for the rest of your life, but you're also limited in your compensation.
In contrast, working for a financial firm, or a tech company like Google has plenty of upside
reward potential in the form of stock or other incentive compensation. But the enterprise also has
more of chance of failing."
Investors and employees alike may want to be aware of their appetite for risk and adjust
their behavior accordingly, says Hill. It doesn't have to be a crap shoot, however.
"First, pay attention to the company and its place in the economy during the last decade or
more," he says. "Did the firm outperform, underperform or match the economy? How well did it do
during economic slumps and shocks?"
Hill also suggests checking a company's bond rating and considering it as part of a broader
review that includes current and past financial performance.
"Finally, consider how well the company's strategies line up with economic trends," Hill
says. "If you believe the economy will grow, then think about whether a firm that you invest in or
work for is likely to benefit as consumers' disposable income grows. If the company's goods or
services do not align with the economy's trends, it might be worthwhile looking for another
business to work for or to invest in. Either way, think seriously about whether you're comfortable
with the company's risk-reward profile."
