JSE listed companies have been beating down on themselves very heavily. Kabelu Khumalo reports some R250 billion of recent write offs and write downs of assets. (BD August 12th) It will mean that the book values recorded on the balance sheets perhaps will accord more closely with the market value of the company. Yet the cash flows of the business would be unaffected by the action and there are unlikely to be any taxes saved on the losses because they will not be recognised as a business expense. And the bottom line will be even less meaningful.
The prior damage done to cash flows and market value by poor investments or acquisitions will long have been recognised and deducted from the value of the company by investment analysts and the investors they advise. They will have made their own diminished sum of parts calculations of the present value of the divisions of any company. And they may still have a very different view of what the underlying assets might bring shareholders in the future.
Notice something important about these adjustments to the books designed to align book and market value. There is very unlikely to be an equivalent urgency to upvalue the assets on the balance sheets that have proved to be market value adding. The great new mine that has proven to be so valuable to shareholders is likely to remain on the books at something close to its historic costs. Not written up in the books to enhance earnings and equity capital employed and the strength of the balance sheet. And when an excellent acquisition was made paying above the book value of the company acquired, this goodwill is very likely to be amortised against earnings, so reducing book value and the capital employed by the business. Rather than logically seen as adding to the amount of valuable capital employed by the business.
The benefits of writing off capital employed in a business, rather than writing it up, will show up in an important measure, and that is as Return on Equity Capital employed (ROE) The less capital recognised the better the return on equity all other operating details remaining the same. And the managers of the business are very likely to be rewarded directly on the basis of ROE. Shareholders will benefit when the company they entrust their savings can deliver a return on the capital they employ that exceeds the opportunity cost of capital employed. That is the returns shareholders might expect investing in an alternative company with similar operating risks.
Making poor investment decisions reduces ROE. Recognising past failures will not change past performance. It might however indicate that milk has been spilled, that costs have been sunk, that bygones are bygones and most important that more good money is less likely to be thrown away on lost causes. And if the managers are surprisingly contrite might help add market value by improving expected performance.
But what could be more helpful to an incoming CEO, also to be measured on future ROE’s than to begin a reign with less capital? True kitchen sinking, recognising the mistakes made by predecessors, could be managers wealth enhancing, if future rewards are to be based on higher ROE’s, as indeed they should be.
If the actual capital entrusted to the incoming CEO and the team of operating managers is accurately measured, it is only then that improvements in ROE can be properly recognised and encouraged. And rewarded appropriately in all the operating divisions whose managers can be held responsible for the capital they are given to manage, again accurately estimated.
South African directors of companies now burdened with justifying not only what they pay their senior managers, but with also justifying the absolute difference between the rewards at the top and bottom of the pay scales, may point to the example of Starbucks. Changing their CEO yesterday immediately added over 20 billion dollars to the market value of Starbucks. Paying the right CEO enough, not too much, nor too little, rewards based predominantly on improvements in ROE, properly calibrated and communicated, should be the primary task of any Board of Directors. And when put into good practice with successful and well and competitively paid CEO’s, will deserve the approval of shareholders.