analysts and investors. There are, however, some serious drawbacks when it is not used with great discretion. First, there are the difficult measurement problems of associating costs and benefits to discrete and relatively short time periods. Rapid changes in technology and price levels further compound the measurement problems. More recently, with the accelerated use of convertible bonds, convertible preferred shares, warrants, and stock options, the question of the number of shares that should be used in calculating per share returns has been significantly complicated. Yet another complication arises when one of the terms of a merger which the company may have recently consummated states that the number of shares to be issued to the selling shareholders depends upon the future earnings of the company acquired. An even more basic consideration than the problems associated with measuring earnings per share is the question of whether earnings is an appropriate measure of return within the framework of the valuation models presented earlier in this chapter. The reason is that the use of earnings will involve double counting. To see how this arises, note that the portion of earnings that are retained give rise to a growth in earnings in subsequent years. The impact of these retained earnings is captured by the term "g" in the expression R/(k-g). If we consider the numerator R to be total earnings, we have counted the retained earnings twice. We can adjust for this double counting by subtracting the amount of retained earnings from the earnings figure used in the numerator. When we do this, however, we are, in effect, considering dividends to be the numerator of the valuation equation. Thus we restate equation 6' as: (6'') Po = k Di g where D1 represents dividends paid to shareholders in period 1.1 The idea that the price of a share of stock should depend upon the future dividends to be paid on that stock, including the final liquidating dividend, has been succinctly summarized: "In the last analysis, dividends are all that investors as a whole receive from a stock. They may, of course, also reap appreciation (or depreciation) in market value if they sell their shares. However, the selling price is itself assumed to be a function of expected future dividends at 1 For a more detailed discussion of this point see Alexander A. Robichek and Stewart C. Myers, Optional Financing Decisions (Englewood Cliffs, N. J.: Prentice-Hall, Inc., 1965); and Eugene M. Lerner and Willard T. Carleton, A Theory of Financial Analysis (New York: Harcourt Brace & World, 1966). the time of sale. Ultimately, the shares will find their way into the hands of an investor who will hold them through final liquidation of the enterprise. Plainly, all that he will receive from the shares is the dividends that will be paid on them. The amount that he will be willing to pay the penultimate holder will depend upon his expectations of the dividends remaining to be paid. This valuation process may be extended backward in a like manner through the chain of owners of the shares."2 If we adopt equation 6'' as the basic valuation framework, what is the value of earnings data? The answer is that earnings are important for two reasons. First, Lintner3 observed that after a corporation achieves a sustainable earnings increase, it will increase its dividends, and once they are raised, every effort will be made to prevent them from falling below their new level. A change in earnings, therefore, indicates a change in the level of dividends. Perhaps more importantly, a change in the rate of growth of earnings forecasts a change in the rate of growth of dividends. The reason for this is that many firms try to retain a fixed payout ratio; hence, as earnings grow more rapidly, dividends are likely to increase their growth rate as well. Investors employing the valuation framework expressed as equation 6"", may properly assume that as "n" becomes larger the average annual growth rates for earnings and dividends will converge. In this case, the growth rate of earnings (g*) may be viewed as a proxy for the growth rate of dividends. The modified equation is expressed as follows: Po DI (6'''') In light of this, accounting reports for diversified firms should be designed to provide the investor with a basis for estimating the growth rate in earnings per share (g*) for the firm as a whole. To summarize, the valuation frameworks now employed by investors depend upon forecasts of what the future stream of returns will be. If an investor assumes that earnings per share is a useful measure of return and that it will remain constant through time, then equation 3′′ 2 James T. S. Porterfield, Investment Decisions and Capital Costs, Englewood Cliffs, N. J.: Prentice-Hall, Inc., 1965. Graham, Dodd, and Cottle in perhaps the most influential text in the field of security analysis write: "This predominant role of dividends has found full reflection in a generally accepted theory of investment value which states that a common stock is worth the sum of all the dividends to be paid on it in the future, each discounted to its present worth." (Security Analysis: Principles and Techniques, 4th edition, New York: McGraw-Hill Book Co., 1962, pp. 480-1.) 3 John Lintner, "Distribution of Incomes of Corporations Among Dividends, Retained Earnings and Taxes," American Economic Review, May 1956. captures all of the essential features of this framework. For once a discount rate is selected, the current earnings figure need only be capitalized at this rate to arrive at a value for the shares. Typically, however, the investor will assume that some growth in return will take place. The specific discount rate that will be used to capitalize the current earnings stream or the multiple that will be applied to reach an estimate of market price of the stock will depend in large part upon this estimated growth rate. Thus, equations 6′ or 6′′ are valuation frameworks commonly used by investors. The central problem in corporate disclosure, therefore, becomes one of designing reports that structure the financial data of the firm in such a way so that investors can make informed judgments about the parameters in their valuation models. Specifically, data must be disclosed so that judgments can be made about both the current level of earnings and the future growth of earnings. In the next chapter we will illustrate this point more fully. Chapter 3 Segmented Earnings Statements THE HE PER SHARE RETURNS that a corporation will generate over some future period and therefore the growth rate it will achieve can be estimated in a number of different ways. Not all of the methods can be enumerated here, nor are all particularly relevant to the corporate financial disclosure problem. In this section however, we shall sketch the broad outlines of some of the methods that investors have used to estimate future earnings, and we shall indicate the relevance of each technique to the financial disclosure problem. 1. Forecasting returns through industry analysis One method of forecasting the future returns that a company's security will yield is to focus attention on the industry to which the company belongs. The forecast of the industry performance can be arrived at in several different ways. Specific demand and cost factors affecting the industry can be studied and a qualitative determination can be made of how they are likely to change over some future time period. Alternatively, a statistical study can be made of the relationship between the industry and some gross macro-economic variables such as consumer spending or industrial production. Then once the gross macroeconomic measures are estimated, the relevant industry statistic can be computed. After the estimate of future industry conditions is prepared the investor must still determine the company's relationship to the industry as a whole. Thus, if an investor is considering the automobile industry, he may estimate the industry-wide sales figure in some future year as x million. The specific share of the market that will be gained by General Motors, Chrysler, Ford and others must then be determined for investments are made in the securities of specific companies, not the in 15 dustry as a whole. The market shares of these companies have not remained constant over time. Nor has the ability of these companies to translate sales growth into earnings growth been constant. As a consequence, investors using an industry framework to forecast future company earnings require data about the company itself, as well as data about the industry. These data can be of a financial character, such as the expenditures on new facilities that the firm has underway. Frequently, however, investment data are nonfinancial in character. For example, knowledge of the changes that the company has underway in, say, its distribution system or perhaps its management may be helpful in estimating future earnings. The valuation problem associated with such an industry type analysis is even more complicated than the above remarks indicate. The reason for this is that most companies sell in more than one market and operate in more than one industry. Thus, a manufacturer may sell to three markets within the industry; government, wholesale, and retail markets. Moreover, the company may also be in the glass business, the chemical business and still other industries far removed from the technology associated with the company's major product line. For an investor to use effectively the industry framework for valuation purposes, it follows that knowledge of the different products and/or markets in which the company operates is essential. The contribution that each segment makes to the firm's overall performance must also be known, for different segments of an industry offer different opportunities for future growth. Finally, ancillary data such as the investment outlays that are being made in each industry segment must be determined. These data give the investor an indication of the company's intention to participate in the future of the various industries and markets it serves. To summarize, one way an investor might develop an estimate of the future growth in a company's earnings is to start with an estimate of the future sales growth of the several industries in which the company operates. The ability of the company to continue to participate in the growth of each industry must then be estimated. The implication of this estimating procedure for corporate disclosure practices is that income statement figures should be disclosed along industry lines. Industries, however, are not homogeneous. Some markets within an industry may be growing at a different rate than other markets. When this occurs, some finer breakdown of corporate activities than industry itself is required for adequate disclosure. Additionally, segmented source and application of funds data are required to give the investor an indication |