Thursday, February 21, 2008

Is all Income Value Accretive ?

In equity markets, when evaluating businesses, whether an investment is sought to be made through an IPO / secondary market or private equity investments (PIPE deals / unlisted Co's), to my mind any prudent investment manager / investor evaluating Company financials, profile and the business model would seek answers to two principle questions
1. How big can this become (scalability) ?
2. How sustainable will this be (returns on capital employed) ?
It therefore follows that one would make an assessment of value of business on sustainable profits / turnover / cashflows & at what Internal rate of return (IRR) the cash flows are again likely to be re-invested (right scaling up of business!).
What can be sustained ? Only that which adds value and is something which would survive by natural selection i.e. fit to withstand competition and grow. This is then a quality test and not a quantum test (which i presume models would not capture, since this is not binary but will put to use one's experience and judgement).
Across all media valuation multiples are reported using total earnings i.e. the earnings no does not even provide for a simple differentiation between earnings from regular business activities and earnings attributable to other income. It is without dispute clear to me that media cannot be expected to provide sustainability calls on earnings but, atleast a better earnings no can be reported.
The last quarter ended Dec 07 results earning per share growth has almost entirely been on account of increases in other income, which to my mind go straight to the bottomline (one may check CMIE data or broker aggregate results updates for the top 100 cos or so), thereby inflating the earnings no (EPS) and consequently lowering the valuation multiples (making things look cheaper or rather less expensive than they are !!!
Rising other incomes is a cause of concern. The concern is - are companies booking profits on some of its investments to show / maintain profit growth or deploying surplus cash on its balance sheet in the equity markets / banking system to generate higher income. In the former case, it is an indication of a slowdown in earnings which the Company does not want to acknowledge and the latter indicates that the Company does not have avenues to deploy additional cash thereby affecting the IRR at which cashflows are invested & consequently the sustainibility of current earnings. Beyond a certain level, this is also a corporate goverance issue.

1 comment:

pm said...

What happens if other Income is of recurring nature...for example sale of scarp generated from production, or an intrest income on some long term debt held by the company?

Should we be concerned about the other income even if it is recurring in nature and it appears that it will continue for substantial period and if anything will help increase the overall cashflow?

Another thought...how should non recurring income impact the valuations? Should expected windfalls be included if I am valuing a firm over next 15 years....or should I moderate these windfalls, given that the risk is substantially high because of long tenor?