Did you know that many FTSE companies inflate their profits so that they look better for investors?
Did you know that this was 100% legal?
Most investors don’t have a clue about this. They don’t know what to look for. Investors assume that if profits are rising from the previous year then things must be great. They’ll make the decision to invest in a company purely off those simple numbers, without understanding what’s going on behind them.
Sometimes you need to look a little deeper and understand where that profit is coming from.
So how do companies inflate their profits? And how is it legal?
Let me explain.
After analysing over 10000 years of financial data across 1000 FTSE companies, you’d be suprised just how many of the numbers you should not take at face value.
When reviewing a companies financial reports we need to identify where the profit is coming from. For me there’s two types of profit.
Type 1: Profit from the recurring everyday business
Type 2: Profit from the Sale of Assets
Let’s quickly take a closer look at both of these
Profit from the recurring everyday business
This is the profit the company make from their EVERYDAY business. It’s the profit we care more about.
If the company was Howdens Joinery plc [LSE: HWDN] then this would be the profit they made from selling say 1000 kitchens and furniture that year. It’s RECURRING revenue coming into the business as they sell kitchens every day across the year.
This profit is a huge measure of their businesses performance as it will be the lifeblood of their future. If they dont make profit every year selling their kitchens, then they have a serious problem on their hands. How will they grow as a business if they don’t make a profit selling their product or service each year?
But there’s other ways companies can make profit, and here’s where it gets misleading.
Profit from the Sale of Assets
Companies can often sell their assets.
Assets can be anything they own that generates income for the business. There are two types of assets you need to understand. Tangible (you can touch it) or Intangible (you can’t touch it).
Examples of Tangible Assets could be:-
- Inventory the company have in stock
- Company vehicles
- Property and Buildings
Examples of Intangible Assets could be:-
- Rights to use
- Logos and Branding
- Data/Customer Lists
Any of these assets can be sold, at any time. Often the sale of these assets can be strategic.
Perhaps the company are not making so much profit from their USA branch of their business. So, they’ll decide to cut it off and re-focus it’s efforts on it’s UK core business.
Well, that US aspect of the business may be sold off to another business for a fee. Sometimes, these fees can be substantial.
The key here is that these are “one-off” events. You can’t sell the US arm of your business again next year or the year after that. Ultimately, selling off assets will inflate their profits that year, but they are not reflective of the business performance of the company.
Understanding Where the Profit Comes From
It is therefore crucial to understand where the profit is coming from.
Companies are obliged to report both types of profits. So therefore, what they are doing is entirely legal. They are doing nothing wrong as such. It is profit afterall.
But investors will go mad about how a company made a record £50m in profit and fail to notice that profit from their recurring business actually fell that year! The profit was due to sale of an asset.
The onus is therefore upon the investor to know how to read the financial reports. It is our responsibility as investors to know what we are looking at.
For example, Tesco plc [LSE: TSCO] reported in their 2018 financial reports that they made £1.2 billion in profits. Of course, this is entirely true. They did make £1.2 billion in profits. However, only £878 million of that was actually profit from their everyday recurring business (mainly the sale of groceries across their many stores). If you analyse the reports correctly you’ll see that £330 million came from the one-off sale of assets listed as “other income”. And yes, accounts are still allowed to use the ambiguous phrase “other”.
In 2015, GlaxoSmithKline plc [LSE: GSK] reported that profits had risen from 2014’s £2.8 billion, to £8.3 billion. Imagine the investors licking their lips at these reported numbers.
However, investors who knew how to analyse these numbers would have found that £8.8 billion came from the sale of assets that year, not the recurring revenue of the business. In fact, after removal of the this extraneous income, GSK’s everyday recurring revenue actually made a loss of -£529 million that year.
I don’t know about you, but that’s information I’d want to be clear on as an investor.
Now the above examples don’t tell the whole picture of either of these companies. I’m just using these aspects of their reports to highlight the need to dig a little deeper.
Why Inflate Their Profits?
You can read the annual reports of these companies for those years and witness them celebrating their wonderful profits. But to me, this is misleading for investors who don’t know any better.
Companies have an incentive towards keeping the details hidden away. When their incentive is to raise the number of investors in the business, it is obvious that these companies will do everything they legally can to make their company more attractive.
Why willingly advertise bad results? It sounds far more impressive for the annual report to show the £8.8 billion in profits than it does volunteering that the recurring everyday aspect of the business made a loss.
And they are legally doing nothing wrong. They are simply reporting their profits. These are technically facts. They are not lies.
They are just choosing which stats and numbers to show you, and which ones they’ll make you dig for. Knowing full well, most investors don’t even bother to read past the summary pages of the annual reports, if they ever read them at all.
You can also bank on the fact these companies will change the way they report on their figures almost yearly to put a “positive spin” on their results.
For example, it’s quite common for companies to create a tradition of reporting their customer service scores when they are above 90%. They will do this for a decade without fail.
However, suddenly you’ll find they don’t report on that anymore in their annual report. There will be no mention whatsoever. Then the following year they’ll be raving about how their customer service score has risen a whopping 30% this year to 78%.
Remember, most investors don’t read the reports. Those that do read 2020’s report won’t remember what was being said in 2018’s report.
They’ll simply see the +30% rise in customer service score and think “wow, thats great”. Not realising customer service is still down 12% from where is was just a few years earlier.
Stats are easily manipulated. Memories are short.
It takes someone dedicated to diggin deeper to find out what’s actually going on.
So the next time you want to know which stocks to buy, don’t trust the company to show you the real picture. Remember that they inflate their profits. Dive deeper and identify what’s really going on. Otherwise you may find yourself wasting money and crucial years backing a lame horse.
And if you want someone you can trust to do this for you? Come and join our exclusive membership program where I send you my analysis on my 53 recommended companies from the FTSE market, every single week.