What’s the best way to measure corporate performance?
What’s the best way to measure corporate performance?
Corporate earnings reports are sort of like report cards for public companies. Investors and analysts pore over them, looking for clues about the future.
“We really don’t care just about what happened in that period. We care about making a prediction or forecast of what comes next,” said Patrick Badolato, an associate professor at the McCombs School of Business at the University of Texas at Austin, who teaches students to analyze financial statements.
But distilling the information in those detailed reports down to something useful for decision-making — like buy or sell — is complicated.
“For an analyst or investor, it’s really easy to look at a company’s net income,” said Leila Peyravan, an assistant professor of accounting at the Jones Graduate School of Business at Rice University. “But there are a couple of issues with that.”
One issue is that net income includes line items that are highly dependent on management’s financing and accounting decisions — but are unrelated to a company’s core business operations.
Imagine a company that sells pencils, for example. The pencil company’s tax expense could fluctuate depending on tax policy in the state where the company is headquartered or incentives from the government.
Though tax strategy affects the company’s bottom-line net income, it doesn’t have much to do with making pencils. That could make it tricky to compare this pencil company’s performance to another pencil company in a different state.
Similarly, imagine this pencil company took out a loan in a particular quarter. The company’s interest expense would increase and its net income would fall, even if it made the same number of pencils and sold them for the same price as the quarter before.
“So they have all these other items … that you as an investor might not necessarily want to look at,” Peyravan said.
One thing the investor could do is check a company’s “EBIT,” which stands for earnings before interest and taxes. It calculates what the company’s earnings would be without taking interest and taxes into account.
The investor could also consider one of EBIT’s cousins, such as EBITDA (earnings before interest, taxes, depreciation and amortization) or adjusted EBITDA, which remove even more line items from the equation. There is also a variety of other performance metrics, including operating income and cash the company generates.
But what’s the best way?
“Well, there isn’t one,” said Badolato at the Unversity of Texas at Austin. “And there’s flaws of every approach.”
Consider Amazon’s fourth-quarter results, for example. A huge chunk of its earnings — nearly $12 billion — came from an investment in Rivian, the electric car company that went public in November.
“That’s not really related to their core business of [Amazon Web Services], and an online marketplace, and an advertising platform, and all the other things that Amazon’s doing,” Badolato said.
In the simple example of the pencil company, EBIT would help you isolate revenue and expenses related directly to the core business of making pencils, but as Badolato detailed in a series of posts on LinkedIn, that approach would not tell the full story for Amazon.
“The gain from Rivian did happen, but it’s clearly not something that’s going to be a recurring part of their core business,” he said.
For Wall Street analysts or armchair stock-pickers trying to assess Amazon’s performance, Badolato said, no number, by itself, could perfectly summarize its business.
“We latch on to financial metrics because they seem to tell a nice and neat and tidy story, and the reality is messy and nuanced.”
When it comes to Amazon or that pencil company — or the U.S. economy, for that matter — context is everything.
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