Annual reports and shareholder value

Are annual reports (EPS) useful to calculate shareholder value?

Are financial reports useful to determine corporate value?

Although the relevance of traditional financial reports and Earnings per Share (EPS) are heavily criticized, as of today they still remain the most widely used method of communicating the historic performance of companies.

One cannot use historic performance as any guarantee of future returns. This simple fact already renders annual reports useless as far as estimating future value creation is concerned.

Additionally there are several more reasons why earnings (accounting profit) fail to reliably measure the economic value of firms. They are:

1. Alternative accounting methods may be employed (both required changes by FASB or IAS and voluntary changes can change reported earnings, but do not affect economic value),
2. Risk is excluded (both business risk and financial risk are not accounted for in annual reports),
3. Investment requirements are excluded (changes in for example the working capital are not considered in reported earnings),
4. Dividend policy is not considered (for example dividend decreases will show increased reported earnings but are in fact value neutral),
5. The time value of money is ignored (no present value calculation in reported earnings).

Over the last 10 years, an additional 6th major reason has appeared:

6. The increased role intangibles play in our economic system, which has moved from an industrial economy towards a services and knowledge oriented economy.

Although intangible assets have been around since the dawn of civilization, due to certain factors, including increased competition (globalization, deregulation) and the advent of information technology (notably the internet), the structures of corporations were changed.

This combination of factors catapulted the relative significance of intangible assets in the eighties and nineties of the 20th century compared to their tangible peers into the major value drivers of business in our modern economy:
- In 1978, 5% of all assets were intangible
- In 1998, 72% of all assets were intangible
- Currently, 75-85% of all assets are intangible
So the cause of decreasing significance of accounting for value determination is not an attempt to mislead investors, market makers, managers or governmental agencies by accountants.

Intangibles are generally still not regarded as assets in traditional accounting systems.

The consequences of above described shortcomings of annual reports on Value Creation are severe.

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