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A lot of investors may be worrying about the US current account deficit and the outlook for the oil price but for many European fund managers, the biggest headaches of the year may result from the introduction of International Financial Reporting Standards (IFRS).
The new standards are likely to result in wholesale changes to the reported numbers of European companies, throwing valuation screens into some confusion. And it is not clear whether European companies are ready for the shift or that market prices have already adjusted.
The biggest change is set to be the removal of goodwill amortisation. Europe is moving to the US system, adopted in 2002, whereby goodwill is not automatically amortised but subject to annual "impairment reviews". In the short term, this will boost European earnings per share by 19 per cent, according to Morgan Stanley. But it means that any future adjustments to goodwill will be lumpy.
Has the market priced in this change? No, according to Morgan Stanley. It points to a disconnect between US and European valuations that dates back to 2002 suggesting investors did not adjust European earnings to a pre-goodwill basis.
That gives scope for the valuation differential to narrow once the goodwill burden is lifted from European stocks.
However, Lehman Brothers argues that the market has been ignoring the goodwill effect. It analysed the relationship between market valuation and the return on capital employed over the 1988-2003 period. When goodwill is deducted from earnings, the relationship appears to be non-existent. But if goodwill is added back in, there is a clear relationship between the two.
Another significant issue is the expensing of options. The fair value of options granted will be amortised over the vesting period and charged to the income account. Technology and media companies are likely to be hardest hit by the change; Lehman estimates that advertising agency earnings will fall by 6.0 per cent because of this change.
Then there are pension changes. European companies will be adopting a standard similar to the UK's FRS 17, whereby the difference between the market value of the assets and the discounted value of the liabilities is taken on to the balance sheet. This could have a significant impact on net asset values.
Should any or all of these changes matter?
In theory, markets are supposed to be efficient and to ignore accounting considerations. On the other hand, look at the efforts the corporate sector makes to manipulate quarterly earnings numbers or its penchant, in the US, for making aggressive assumptions for pension fund returns, so as to boost earnings in the short term.
In any case, the process of adjustment from one set of standards to another may catch some companies unawares. As Morgan Stanley points out, small companies are likely to be less prepared (and to have been less efficient at briefing investors) than large ones. So we could see some "shocks" and even delayed results this year.
Then there is the use of valuation screens to look for cheap stocks. A lot of changes may occur to the data. For example, Morgan Stanley estimates the return on equity for European companies will rise by 270 basis points while book values per share will fall by 4.0 per cent (because of items like pensions and convertibles). Confusion may be increased because companies will have the opportunity of smoothing accounts so as to delay the full impact of IFRS until the 2005 results (posted in 2006).
Among all this potential chaos, the one measure that will not change, dividend yield, may become much more popular.
Finally, there is the issue of overall measures of market valuation. IBES (the Institutional Brokers' Estimate System) has been defining European earnings on a post-goodwill but pre-exceptional basis. It plans to move to a pre-goodwill measure this month. At some subsequent stage (presumably when most analysts are making forecasts on this basis) it will move to the full IFRS definition.
So making statements such as "European shares look cheap" or "this sector looks expensive relative to its US counterpart" could be fraught with danger over the next 12 months.
If you are not fully briefed on the accountancy changes, you may be bamboozled by the market. (Source: Internet, exclusive to FE)
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