Inside Investor Relations – Volume 15: The Case for Disclosure Beyond the Requirements of GAAP

Photo Credit: https://blog.pareto.network 

Generally Accepted Accounting Principles (GAAP) are a set of rules that encompass the details, complexities, and legalities of business and corporate accounting. It is intended to improve the clarity, consistency and comparability of company information disclosure.

When an investor meets with a company, they are looking for three things: an understanding of how the company has performed in the past, a clear picture of what the company is now, and an idea of how the company can drive sales and earnings growth in the future.

Historical GAAP disclosure can provide a decent, but not perfect, picture of the first two, but only management can provide the framework for an investor to understand how management plans to drive sales and earnings growth in the future.

A definition of information asymmetry

To understand why it is important to help investors better understand how the company is investing in future growth, we’ll take a look at the concept of information asymmetry. To define the term: information asymmetry occurs when one party to a transaction has more or better information than the other.

In the case of a listed company, management has an informational advantage over the investor. The investor sees only what is publicly available in terms of GAAP disclosures and news about the company in the media. Management sees all of that and possesses insider knowledge about any manner of fundamental information such as pending contracts, progress on innovative products and industry trends.

Reducing information asymmetry reduces a company’s cost of capital

Research has shown that companies who have a coordinated program to reduce this information gap achieve higher valuations. For example, consider the following benefits:

In 2003, Luzi Hail found that Swiss companies that follow a practice of enhanced disclosure had a cost of capital 2.5 percentage points lower than those who were less generous in sharing company information.

In 1999, Paul Healy, Amy Hutton and Krishna Palepu found that enhanced disclosure increases the number of analysts following the company and the size of its institutional ownership.

Furthermore, studies in the US have shown that improved disclosure decreases the stock’s bid-ask spread. As this means a lower cost to investors, it also reduces a company’s cost of capital.

Using simple math and the dividend discount model, let’s quantify just how powerful this effect can be. We’ll assume that the median cost of capital in a market is 9%, growth for all companies is equal and the median dividend is $5 per share. The company with enhanced disclosure would have a cost of capital of 7.75% and one providing only GAAP disclosure would have a cost of capital of 10.25%. This assumes that the median company provides some level disclosure above pure GAAP requirements, and the companies with ‘enhanced disclosure’ provide more than the median company. Using these assumptions, the positive disclosure company would have a share price of NT$64.5, while the bare minimum disclosure company would have a share price of NT$48.8. That is a 32% premium. Consider what an advantage this is in terms of raising funds or providing stock bonus payments to employees.

Examples from history

On May 16th, 2006, Home Depot announced positive earnings and sales news, yet its share price dropped by 6% on a day that the S&P 500 dropped by only 2%. Why was this? During the company’s analyst meeting, it announced that it would no longer include data on same store sales growth – a metric widely followed by the market – in its investor conference disclosures. Investors were giving a clear indication of what they thought of Home Depot’s change in disclosure policies.

A couple of years later, Netflix provided this detail in its quarterly earnings release (see table below).

Netflix Voluntary Disclosure, 1Q08

This disclosure provides a clear snapshot of how much Netflix was investing in generating new business, how sticky the new business was (lower churn is better) and the payoff from these investments in terms of new revenue from subscribers. This is all information that the investor can use in terms of developing a picture of how the company’s revenues, costs and earnings may grow (or decline) going forward. In 2008, Netflix traded at an average of 30x sell-side analysts’ consensus forecasts versus the S&P’s all-time average of 16x. This high PE showed investor confidence in Netflix’s growth prospects; and Netflix’s voluntary disclosures were likely an important factor in helping investors to produce their forecasts for future growth. In other words, we believe the disclosures contributed to Netflix’s higher-than-market average valuation.

Pointers on the effective use of voluntary disclosure above what is required by GAAP

Based on our experience, here are some pointers regarding the effective use of voluntary disclosure.

Enhance accountability by using milestones: GAAP does not provide investors much help in understanding potential changes in a company’s forward-looking prospects that may result from innovation and R&D investment, restructuring or investments in brand value creation. When voluntarily disclosing your efforts in these areas, be systematic and provide information on targeted milestones and the company’s progress towards those milestones.

Keep track of analyst coverage and forecasts: Pay attention to the number of analysts that cover your stock, how frequently they publish reports on your company and how widely their earnings estimates vary. Greater analyst coverage will enhance liquidity in the trading of your shares, and a tight range of analyst estimates will lead to a more stable share price and a lower cost of capital.

Be Consistent: Transparency and communication with minority investors is a long-term commitment. Maintain the same level of voluntary disclosure in good times as you do in bad times. When you omit certain items that used to be included in your quarterly investment presentation, investors will assume that the company has reason to be hiding something.

Rely on fact-based exposure and avoid hype: Disclosure about an investment in a new factory can be accomplished with data such as projected capex, capacity and potential revenue generation or with overly optimistic speculation about future profits and market share. The former will provide investors with tools to evaluate the merits of the new investment, while the latter will result in a loss of credibility if results don’t meet the hype.

It is important for listed companies and their IRO to communicate with investors accurately and effectively. QIC advisors consist of experienced professionals that have worked in major sell-side and buy-side companies for many years. We help companies to formulate their strategies through our understanding of the industry and in-depth interviews with the management team. We also help facilitate the meetings with various types of investors. If you are interested in learning more about our services, please reach out to us.

Contact: yvonnehuang@qtumic.com