Ask investors what kind of financial information they want companies to publish, and you'll probably hear two words: more and better. Quality financial reports allow for effective, informative fundamental analysis.
But let's face it, the financial statements of some firms are designed to hide rather than reveal information. Investors should steer clear of companies that lack transparency in their business operations, financial statements, or strategies. Companies with impossible to understand financials and complex business structures are riskier and less valuable investments.
What Are the Benefits of Transparency?
The word "transparent" can be used to describe high-quality financial statements. The term has quickly become a part of mainstream business vocabulary. Dictionaries offer many definitions for the word, but those synonyms relevant to financial reporting are: "easily understood," "very clear," "frank," and "candid."
Consider two companies with the same market capitalization, overall market-risk exposure, and financial leverage. Assume that both also have the same earnings, earnings growth rate, and similar returns on capital. The difference is that Company X is a single-business company with easy-to-understand financial statements. Company Y, by contrast, has numerous businesses and subsidiaries with complex financials.
Which one will have more value? Odds are good the market will value Company X more highly. Due to its complex and opaque financial statements, Company Y's value will likely be discounted.
The reason is simple: less information means less certainty for investors. When financial statements are not transparent, investors can never be sure about a company's real fundamentals and true risk. For instance, a firm's growth prospects are related to how it invests. It's difficult, if not impossible, to evaluate a company's investment performance if its investments are funneled through holding companies and hidden from view.
A lack of transparency may also obscure the company's debt level. If a company hides its debt, investors can't estimate their exposure to bankruptcy risk.
High-profile cases of financial shenanigans, such as those at Enron and Tyco, showed everyone that managers may employ fuzzy financials and complex business structures to hide unpleasant news. An overall lack of transparency can mean nasty surprises to come.
Clarity: My Favorite Term
Why Some Companies Struggle With Transparency
The reasons for inaccurate financial reporting are varied. A small but dangerous minority of companies actively intend to defraud investors. Other companies release information that is misleading but technically conforms to legal standards.
The rise of stock-option compensation increased the incentives for key employees to misreport vital information. Companies have also increased their reliance on pro forma earnings and similar techniques, which can include hypothetical transactions.
Then again, some companies just find it difficult to present financial information that complies with fuzzy and evolving accounting standards.
Complexity Adds Challenges
Beyond that, some companies are just simply more complex than others. Many operate in multiple businesses that have little in common. For example, analyzing General Electric (GE) — an enormous conglomerate with numerous lines of business — is more challenging than examining the financials of a firm like Netflix (NFLX), a pure-play online entertainment service.
When firms enter new markets or businesses, the way they structure these new businesses can result in greater complexity and less transparency. A company that keeps each of its businesses separate will be easier to analyze and value than one that squeezes all the businesses into a single entity.
The cause of poor transparency, however, is less important than its effect on a company's ability to give investors the critical information they need to value their investments. If investors neither believe nor understand a company's financial statements, its performance and fundamental value remain irrelevant or distorted.
The Bottom Line
Investors should seek disclosure and simplicity. The more companies say about where they are making money and how they are spending their resources, the more confident investors can be about their fundamentals.
It's even better when financial reports provide a line-of-sight view into the company's growth drivers. Transparency makes analysis easier and thus lowers risk when investing in stocks. In that way, the investor is less likely to face unpleasant surprises.