The kitchen sink approach

JSE-listed companies have been beating themselves down lately. There have been in the region of R250 billion in write-offs and write-downs of assets recently, according to Kabelo Khumalo, writing in Business Day.

This will perhaps mean that the book values recorded on their balance sheets will accord more closely with the market value of the company. However, the cash flows of the business will 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. The bottom-line effect 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-the-parts calculations of the present value of the divisions of any company. And they may still have a different view of what the underlying assets might bring shareholders in the future.

Aligning book and market value

There is something important to note about these adjustments to the books that are designed to align book and market value, notably that is there is 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 and not written up to enhance earnings and equity capital employed, and the strength of the balance sheet.  And when an excellent acquisition has been made, paying above the book value of the company acquired, this goodwill is very likely to be amortised against earnings, thus reducing the 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 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 likely to be rewarded directly based on ROE. Shareholders will benefit when the company to which they entrust their savings can deliver a return on the capital they employ that exceeds the opportunity cost of capital employed. In other words, the returns shareholders might expect from 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 importantly, that more good money is less likely to be thrown away on lost causes. And if the managers are surprisingly contrite, it might help add market value by improving expected performance.

The kitchen sink approach

But what could be more helpful to an incoming CEO, also to be measured on future ROEs, than to begin a reign with less capital? True kitchen sinking, recognising the mistakes made by predecessors, could be wealth enhancing for managers, if future rewards are to be based on higher ROEs, as 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. They will also be rewarded appropriately in all the operating divisions whose managers can be held responsible for the capital they are given to manage, again provided it is accurately estimated.

South African directors of companies now burdened with justifying not only what they pay their senior managers, but also justifying the absolute difference between the rewards at the top and bottom of the pay scales, which may point to the example of Starbucks. The change in CEO recently immediately added over US$20 billion to its market value. Paying the right CEO enough – not too much, nor too little, with rewards based predominantly on realised improvements in ROE, properly calibrated and communicated – should be the primary task of any board of directors.  And when this is put into good practice with successful and competitively paid CEOs, it will deserve the approval of shareholders.

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