By Stuart Thomson, Managing Director, Johnsons Chartered Accountants

Profitability has a direct impact on investment decisions. However different measuring standards mean that not all profit is necessarily equal. And how do risk factors affect the bottom line?

So what is profit? Well, accountants will tell you it’s the amount generated in a fixed period, which is available for shareholders. Which accounting standards are being used to express profit? Are we saying that US businesses using US GAAP are different to, say, UK businesses using UK GAAP just because of the application of accounting rules? The accounting standard bodies have been sufficiently concerned about this issue that they created IFRS (a set of international accounting standards). Others will say profit is a function of value or vice versa. But what is included? EBIT or EBITDA. or … ?

Does it really matter? Well, yes and no. Based on the accountant’s definition at the top of this article, it’s fairly black and white. The accountant’s definition takes account of local rules and different accounting standards. But it can also be misleading, because businesses are commonly valued based on their enterprise value (EV) less their debt, to get shareholder value. (Let’s not get into the definition of debt!). A good valuation of equity will make appropriate adjustments for local rules and different accounting standards. Why? Well because the two identical business that operate in different countries using different accounting standards are still identical businesses.

So why does the definition of profit matter if valuers just make black box adjustments to profit anyway? It matters because good business managers drive shareholder value by two means – profit and capital structure. Both are linked, but at their essence they are very different. Capital structure deals with who gets what out of the return of the business’s assets – that includes interest and loan repayments. Profit is about the financial operating performance – crudely, sales less costs.

But these two things miss one very important aspect to shareholder value. What is the difference between:

(1)  a utility company whose return is broadly regulated to provide a standard return on capital and following its population’s change in wealth; and

(2) gambling at a casino playing heads or tails where the odds are 2:1.

The difference is risk and, more accurately, risk-adjusted expected return. I would expect to get my money back at the casino but I’m risking it all on a 50:50 bet. The utility investor has the regulator to thank for the fact that its intervention will mean standard performance (not stellar but it shouldn’t be a write-off either). Risk is a key determinant of value.

So how does risk affect profit? It’s doesn’t directly. But over time, risk will create greater volatility in returns and, as an investor, if the expected return is the same you can choose to gamble to buy on a down turn, or play it safe with a steady investment. It all depends on your risk appetite.

So how do business managers cope with investors’ objectives when they are largely unknown? In part, it’s about transparency. Discussions with investors explain where you see opportunity (ie, risk of upside/downside) and where things are stable. These communications allow investors to decide capitalisation rates and determine the profit adjustments they need in order to assess value and, in essence, vote on the plans.

One of the large components of risk is the organisation’s capital structure, which dictates how much money goes out the door before shareholders see any value. Typically, this is debt. For example, a property company owns a host of fixed assets, and collects rent. This rent is fairly stable, as rents are fixed over a long period of time. This stability in returns drives up the value of the company, and using the Equity Value + Debt = EV calculation the properties are worth more than more volatile assets generating the same profit. Of course the economist argues that the extra value perceived in the company drives up assets values generally, so the gains are not limited to the company’s assets. This stability in return and high asset value allows investors who wish a fixed but lower risk return to get involved. These are lenders who then take their return before shareholders. This reduces the return to shareholders, and so any change in performance has a magnified impact on shareholder returns. This is called financial risk.

If we look at an asset-light business model, such as a service company, it has no assets to protect its income stream. However, such businesses are typically able to return higher profits which compensate for the extra volatility (ie, risk in underlying profits).

Risk may not affect profit, but it affects the perception of profit.

So how does this help us? The property company manager announces a pipeline of assets that will help reduce risk by spreading profits over more properties – this is diversification. The service company talks about longer-term contracts and renewal rates, so reducing volatility over the short term – this increases stability.

The general attitude to risk sits in a fairly narrow band along a median risk/reward curve. Globally low, and historically low interest rates have meant that investors are willing to accept more risk at the low return end, but at the higher end investors are generally not favouring going to the casino.

The opportunity is to move ones business up the ‘return’ curve without a compensatory change in risk. Private equity has always sought to do this.

1. Take a single/few products company, and start selling globally.
2. Take a product and add variations, to increase marketability.
3. Borrow more, and so reduce the investment such that it is an acceptable level of volatility, transferring a larger proportion of risk to lenders.

Business managers are ideally placed in the modern world to do this without the need for private equity, because the global, connected world means it’s far easier to reach new markets. Augmenting a product to create a suite of similar products is best done by those who know the product and, if Private Equity knows lenders, why can business owners not make the same contacts?

I can hear Private Equity professionals challenging this, and arguing their value. If markets were perfect, and business owners had hindsight, then there would be no Private Equity. Private Equity specialists succeed because they have the capacity to focus on the big picture. Business managers are typically limited by their day to day job, and a more detailed focus. As businesses grow the role of the business manager changes. Management and supervisors deal with the day to day, allowing business owners or the Board of Directors to focus on the big picture.

So what would I invest in? Good question! The answer has to be businesses where the management have the vision and sufficient support to deliver.