Once in a while, you'll come across a big company with a long-term, old faithful founder and CEO -- Warren Buffett springs to mind. But the fact is that most corporate leadership is hired on, and sometimes that means that the interests of your average CEO aren't exactly aligned with your interests as a shareholder.
While you're probably aware of the immense pressures on CEOs to boost quarterly earnings and deliver on analysts' expectations, you might not have thought much about the additional career-oriented expectations CEOs are facing.
But the fact is, massaging financial results isn't just about appeasing shareholders, it's also about securing a solid career with a company. These manipulations can be very economically significant -- so how do you avoid being taken for a ride?
Keep an eye on earnings
In the first years with a new company, CEOs have every reason to want to secure their reputation and show that they are superior to the outgoing CEO -- particularly if their predecessor left because of underperformance.
So how can a CEO secure a great reputation in a matter of a few years, or a few quarters?
The answer is to boost earnings.
In a recent study examining discretionary accruals (including advertising, research and development, and sales, general, and administrative expenses), researchers discovered that in their early years with a new firm, CEOs overstate their return on assets, or ROA, by an average of 1.27% per year.
That's 24% of the average ROA!
In other words, take the earnings numbers under a new CEO with a grain of salt. A 1.27% higher ROA might not sound like much, but it can and should affect your valuation -- particularly if it's a symptom of generalized earnings shenanigans.
Mid- and late-career CEOs
What's interesting is that after they've held on to the job for a few years -- during which time you'd expect that a bad CEO would be found out, healthy ROA or not -- CEOs stop overstating their earnings.
Why? The researchers suggest that this is because once a solid reputation has been established, CEOs want to keep their reputation. Thus, they avoid the risks that come with massaging earnings and go more straight and narrow instead.
That means you should be a lot more concerned about an incoming CEO than one who has been in the job for a few years.
However, you should also keep an eye on earnings in the year a CEO is leaving the firm. The study showed these CEOs are also likely to overstate earnings -- probably to cement that reputation and take advantage of any exit packages.
Take advantage of institutional shareholders
Another interesting discovery is that firms with high levels of institutional ownership don't see such massaging in their results. The researchers found that there's still some level of misstatement, but the extent of it in the new CEO's early years is reduced in the presence of institutional investors.
That's a great tidbit for us civilian investors. If institutional investors can encourage CEOs to be more honest in earnings calculations, maybe they can act as an important driver of improved corporate governance overall.
In all, you'll never know with 100% certainty whether your financial statements are completely kosher or not -- that's just impossible. But you can have an understanding of the incentives the executive team is facing and what to do about it, and this might impact your decision whether to invest.
So in the case of a brand-new CEO or one who's leaving, keep a careful eye on earnings and don't get caught up in the wave if things are sounding just a little bit too rosy. You might just be experiencing the externalities of some very clear career ambitions.