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Our core objective as investment professionals is to analyse the fundamental drivers of long-term shareholder value for particular companies, recognising that growth prospects, profitability dynamics, inherent business and product risks, and management’s ability to allocate capital effectively all underpin the ultimate performance of a company in the long run.
Companies are typically made up of a portfolio of strategic business units (SBUs), each focused on a defined customer, product, and geographic target market. Each of these markets face different growth, return and risk profiles, which change in response to prevailing economic, political and regulatory dynamics. This particularly applies to multinationals and conglomerate businesses.
These factors mean we take a ‘bottom up’ view in building an investment thesis for a company and our quantitative models follow that same ‘bottom up’ approach. In certain instances, given the varying risk and return dynamics across SBUs, we value significant SBUs separately, determining a value for a combined company on a ‘sum-of-the-parts’ (SOTP) basis.
We therefore rely on management to provide the financial and non-financial metrics that will allow us to: (1) assess an SBUs historical operational and financial performance; (2) forecast financial performance for an SBU, underpinned by relevant fundamental drivers; and (3) determine an appropriate valuation or valuation range.
Relative comparisons of the above to other SBUs within the company, as well as similar peers, are critical to our analysis. This information allows us to judge management’s ability to effectively allocate capital within a company, as well as the company’s ability to compete successfully in a particular market.
In the absence of consistent and comparable segmental disclosure, markets tend to value companies in a broad-based manner and discount SBU-level competitive advantages. This is punitive to both the company and investors. The company’s investment case slowly diminishes over time, which is reflected in weak valuation metrics and makes raising capital expensive. Investors, on the other hand, may miss potential returns, as weak market sentiment inhibits a re-rating in the stock.
For the benefit of companies and investors alike, the CRUF would welcome more comprehensive, consistent segmental disclosure.
Click the tabs below to reveal what CRUF would like to see for each of these current problems
Currently, companies have a lot of latitude as to how much detail they disclose and the manner in which it is disclosed. Sometimes, segments are simply domestic and overseas.
In some cases, the level of disclosure does not afford investment professionals the information needed to understand the growth, return and risk profile of an SBU relative to its target market and peers.
There is also sometimes a disconnect between the way a company’s business strategy is implemented and the way in which the business is subsequently run, compared to the way in which it is accounted for. This makes it difficult for users to understand how parts of the business operate. Accounting standards say segments should be based on the way measures are reported to the chief operating decision maker (CODM) in internal management reports but, from an analytical perspective, this is not always helpful.
Markets and products face cyclical and secular risks, so it is important for investment professionals to develop informed judgements on how these will impact the company overall, rather than making broad inferences that may be incorrect and weigh negatively on the investment case.
A common sense check on the number of segments separately identified so they are not unreasonably few or too numerous would be useful.
We also encourage management to use the business model as the basis for which it decides to make the primary segmental split so that reported segments do not contain very dissimilar business activities, and so that changes over time may be limited and subject to improved analysis.
We suspect that management teams already manage SBUs in a manner that reflects the unique risks and opportunities inherent in the target markets the SBU faces. If management makes use of multiple views of the income statement and balance sheet to monitor performance, it is most useful if these are provided and are reconciled to the basis used in the consolidated group accounts.
Critically, the comparability and consistency of management’s performance metrics is improved if they are calculated using values presented in the consolidated group accounts.
Investors are interested in calculating various performance metrics to determine an SBUs growth and profitability potential in the long run.
Return on Invested Capital (ROIC), Return on Assets (ROA), Return on Equity (ROE) for each division are key in determining management’s capital allocation astuteness, in particular where capital must be shared across multiple SBUs.
This is not possible if only revenue or profit is disclosed without some operational asset base.
The CRUF encourages companies to consider including the following lines in their segmental disclosures, particularly when management is already using such information to assess segmental performance:
NB: Should the segments change, particularly if this is due to an acquisition, we would welcome the inclusion of comparables for both the historic segments and for the new segments as the company transitions to the new format. This will help us track trends over time and assess progress.