On July 25, 2018, Facebook lost market capitalization of more than $100 billion in just two hours of trading after it announced its quarterly performance, despite exceeding analysts’ earnings forecasts. What caused this slump? It failed to meet its revenue and subscriber growth targets. This example illustrates that investors consider information beyond just earnings as value-relevant. In a recent HBR article, we claimed that modern digital companies such as Uber, Facebook, and Alphabet play an increasingly important role in the economy, but their financial statements fail to capture company’s main value drivers. In a follow up HBR article, we interviewed several chief financial officers (CFOs) of leading technology companies and senior analysts of investment banks and distilled seven key insights from those discussions. Based on these insights, we now propose a new blueprint for financial reporting of digital companies.
Information on revenue and its drivers are, without doubt, the digital companies’ most value-relevant disclosures from the investors’ perspective. The level and trend of a company’s top-line metric is an advance indicator of the success of its business model. The company’s first revenues indicate the acceptance of its product or services by customers. When multiple players compete for the same space, revenues indicate the progress towards achieving market leadership that creates the dominant protocol for industry partners, suppliers, and customers. (In a market like social media, a firm’s success can depend on the winner-take-all profits that come from market leadership.)
Investors, therefore, look not just for reported revenues but for drivers behind the revenues, especially because digital companies’ operating activities often differ from their revenue-generating activities. For example, ostensibly, Facebook’s customers are its daily users (call them “asset units” for argument’s sake). However, the real revenue-providing customers are companies that pay for advertisements (they may be called “revenue units”). The distinction between the two sets of customers, and how the growth in the first set drives the growth in the second set, is a key to investors’ understanding of shareholder value creation.
An analyst following Facebook, therefore, would look for the number of active users, their geographical distribution, their retention rates, the average time they spend on website, and the growth or decline in any of these metrics. Many of these metrics are disclosed in Facebook’s financial statements. However, how those metrics translate into revenues remains a mystery to external investors. For example, whether and how advertisement rates are related to users’ activity hours, whether that rate is increasing or decreasing, whether it differs with geography and customer profile, and how much revenues Facebook derives from selling users’ personal data, are not disclosed in Facebook’s financials. We assert that a detailed statement on the digital firm’s business model, how it translates into revenues, and the trend in principal revenue drivers, must be the most important and foremost disclosure in a digital company’s financial report.
The second item in a firms’ financial disclosures should be a detailed statement of outlays, presented in three broad categories. The first category should describe the amount spent on supporting current operations. While the marginal costs for generating an additional dollar of revenues could be zero, a digital firm must spend large amounts to enhance its offerings and keep pace with competition. Those outlays could be on soft avenues, such as customer acquisition, data breach and safety, regulatory fines, and product enhancement, or on hard assets, such as hardware, servers, and cellphone towers. Those amounts could also be acquisitions required to maintain the firm’s competitive edge. The company should separately present fixed and variable costs, and to the extent possible, detail the variable costs associated with a unit of activity. For example, Twitter provides “cost per ad engagement.” Unlike current accounting rules, which treats inhouse soft outlays as expenses and considers all inhouse hard outlays and acquired soft assets as capital expenditures, we propose requiring deduction of all support outlays as expenses in calculation of operating profits.
The second category should describe the investments on future-oriented projects. By investing in digital companies, investors are often buying call options on moonshot projects with lottery-like payoffs. A firm, therefore, must provide separate, detailed section on the progress of each of its future-oriented project, how it relates to the firm’s current operation, the aggregate resources committed to that project, and the likely launch dates of the project. The current rules mandate no disclosures on future-oriented projects. The current accounting requires all soft, investment outlays to be deducted as operating expenses, and requires all hard investment outlays to be reported aggregated with hard, maintenance outlays. A proper distinction between outlays that merely support current operation and outlays that potentially enhance future revenues is key to investors’ understanding the firm’s current and future profitability. We, therefore, differ from the current accounting practice by requiring distinction between investment and maintenance outlays, and their separate reporting, irrespective of whether they are hard or soft outlays. The company should then leave it to investors’ judgement whether those outlays should be treated as investments, premiums for purchasing call options, or as operating expenses.
In the third category, the company must itemize its so-called one-time, special, or extraordinary items. Our proposal differs from the current reporting practice in one subtle respect. Currently, firms’ first report net profits and then back out many of these one-time items to present a non-GAAP (Generally Accepted Accounting Principles) profit number. Because investors consider these non-GAAP numbers to be value-relevant, we propose a more direct way for them to be calculated.
We propose a separate presentation of all outlays in the three categories described above — support of current operations, investment in future-oriented projects, and one-time items — and then would leave it to investors to ascertain which of those outlays should be deducted in calculation of sustainable profits. Based on disclosures following this blueprint, a smart analyst can project a firm’s future revenues, estimate outlays required to sustain the firm’s business model, and calculate the present value of future cash flows. The analyst can then top that valuation with the option values of moonshot projects.
We also recommend an even more ambitious financial disclosure in which the company can present its assessment of lifetime value of an asset unit. For example, the lifetime value of a daily user to Facebook, a new subscriber to LinkedIn, a new car to Uber, and a new rental unit to AirBnB. Digital companies must be performing such assessments in-house to reward their sales and marketing staff. Investors should have access to those estimates, too.
We assume that the current reporting per GAAP is unlikely to change soon, so investors can obtain information on items such as tax expenses, liabilities, and cash assets from the GAAP reporting. Our proposed blueprint is additional to current regulatory requirements and should serve as a supplementary document to the income statement. Our blueprint can be a part of MD&A section, should not be audited, and should not be subjected to litigation related to forward looking information; otherwise, managers would refrain from providing their private information.
We must acknowledge at least four potential criticisms against our proposed blueprint. First, firms might already be providing a part of this value-relevant information in their annual reports. The problem, in our opinion, is that that the value-relevant information, even if provided, is often miscategorized, aggregated with unrelated items, or buried under boilerplate footnotes. For example, almost no digital company reports wages and marketing expense even though these are large and important outlays.
Second, some may argue that if this blueprint created value for investors, then companies would already be following it, or regulators would have forced companies to follow it. The fact, however, as we have heard from CFOs time and time again, unless companies are forced to follow a blueprint or unless their competitors also start doing so, CFOs would be reluctant to enhance disclosures or present them in a more granular fashion. Furthermore, securities and exchange commission (SEC) and the current accounting-setting boards have failed to substantially change the financial reporting model, making it practically useless for investor valuation.
Third, some would claim that companies will provide biased numbers following this blueprint. For example, a firm could mislabel a product-enhancement expense as a product-development outlay or overestimate the lifetime value of a customer. We believe that investors would finetune their assessments of blueprint numbers over time, based on management’s reputation and credibility. More important, investors would be better off getting managers’ take on those numbers than not having them at all.
Finally, some of these disclosures could reveal private and confidential information to competitors, customers, business partners, and regulators. Yet, we believe that the benefits of disclosures, particularly in improving the efficiency of capital allocation in the markets, outweigh their costs. Therefore, while the proposed blueprint is neither prescribed by the accounting practice nor considered necessary by the SEC, we assert that disclosures following our proposed blueprint are essential for informed investment decisions and to make investors gain confidence in financial reporting again.
This article originally said Facebook’s market capitalization dropped on June 25; it was July 25.
