Finance, Financial Statements and Corporate Disclosure for Communicators (Chapters 7 to 9)

Why communicators need financial literacy

Chapters 7 to 9 argue that strategic communication professionals do not need the proficiency of a Wall Street analyst or an investor relations (IR) specialist, but they do need a working knowledge of finance, financial statements and disclosure rules. CEOs and CFOs talk in numbers, and communicators who can speak finance and accounting as a "second (or even third) language" gain an edge in the C-suite and are better placed to advise on issues such as environmental, social and governance (ESG) performance.

Chapter 7: Finance and the capital markets

Finance and ways to raise capital

Finance is the management of money, or capital. Corporate finance focuses on raising and managing funds to create value for stakeholders; in plain terms it is "getting money" and "managing money" to "make money." Companies can fund growth by (1) reinvesting retained earnings, (2) grants and gifts such as crowdfunding (Kickstarter, Indiegogo), (3) bank loans and lines of credit, (4) selling bonds (debt that must be repaid with interest by an agreed date) or (5) selling stock (equity, which makes the buyer an owner). Stocks and bonds are both securities.

The capital markets

The capital markets are where organizations raise capital and where securities are traded. In 2018 the US securities industry raised $2.4 trillion through debt and equity issuance. The bond market (more than $100 trillion globally) is larger than global equity markets (around $75 trillion). There are around 4,000 US public companies and many thousands more private ones.

Public versus private companies

Public companies list their stock on an exchange and must file quarterly, annual and periodic reports with the Securities and Exchange Commission (SEC), so they must be far more transparent. Private companies usually control who owns shares and may disclose little. Mars, Incorporated, family owned for more than a century, is one of the largest private US companies, with $35 billion in annual revenue, more than 125,000 associates in 80 countries and four segments (Mars Food, Mars Wrigley, Mars Petcare and Mars Edge). Mars has voluntarily become more transparent about its Five Principles, purpose and sustainability commitments.

How the stock market works

A stock exchange matches buyers (the "bid") and sellers (the "ask"). Each listed company has a ticker symbol (for example MSFT for Microsoft, AAPL for Apple). The two largest exchanges are the NYSE ("the Big Board," founded 1792, owned by Intercontinental Exchange, about $28.5 trillion in listed market capitalization) and the all-electronic NASDAQ (founded 1971, about $10 trillion). Indexes such as the Dow, the S&P 500 and the NASDAQ Composite track groups of stocks. Key shifts include the dominance of institutional investors over individual investors, the growth of passive index funds (BlackRock, Vanguard, State Street) and algorithmic trading.

Wall Street players

The company is "the issuer." The CFO works closely with the CEO on financial strategy, and the investor relations officer (IRO) usually reports to the CFO. The buyside (portfolio managers at investment funds) invests capital; the sellside (analysts at brokerage firms) issues ratings and reports. Other players include hedge funds, venture capital firms (fast-growing private companies), private equity firms (mature companies needing restructuring), auditors, law firms, investment banks, proxy solicitors, proxy advisors such as ISS, regulators (the SEC and FINRA) and the business media.

Going public: the Netflix example

Netflix was founded in 1997 by Reed Hastings and Marc Randolph, received a $30 million venture capital investment from Group Arnault in 1999, and held its initial public offering (IPO) in July 2002. Lead underwriter Merrill Lynch helped it sell 5.5 million shares at $15 a share, raising $82.5 million. At the IPO Netflix had more than 600,000 subscribers and about $76 million in annual revenue; it later grew to more than 193 million paid memberships and $20 billion in annual revenue.

The IPO process: a company hires an investment bank, strengthens financial controls, files an S-1 registration statement (prospectus) on the SEC's EDGAR system and enters a quiet period until the SEC declares the filing effective. Executives then go on a road show to fund managers. Later share sales are secondary offerings. WeWork's 2019 prospectus shows how an S-1 can draw scrutiny. In a direct listing (Palantir, Slack, Spotify) a company lists existing shares without a road show or new capital.

Chapter 8: Financial statements and valuation essentials

Rule setters and referees

US public companies report quarterly through EDGAR. The FASB sets generally accepted accounting principles (GAAP); companies reporting non-GAAP measures such as EBIT or EBITDA must reconcile them to GAAP. The PCAOB, formed after Enron, WorldCom and Tyco, oversees audits. The London-based IASB sets IFRS. For ESG, SASB offers standards for 77 industries, alongside the TCFD climate framework and GRI.

The three financial statements

The income statement (P&L) shows revenue, expenses and profit or loss over a period. The balance sheet shows assets, liabilities and shareholders' equity at a point in time, and assets must equal liabilities plus equity. The cash flow statement tracks cash from operating, investing and financing activities. Statements usually compare periods year-over-year (YoY) or quarter-over-quarter. Most federally tax-exempt organizations (e.g., non-profits) must disclose key financial and governance information annually to the IRS on Form 990.

Reading Alphabet's income statement (fiscal 2019)

Revenue ("the top line") was $161,857 million, nearly $162 billion or $161.9 billion, up 18%; more than 83% (nearly $135 billion) came from advertising. Cost of revenues (COGS) was nearly $72 billion. Other expense lines were R&D ($26 billion), sales and marketing (more than $18 billion), G&A (about $9.5 billion) and European Commission fines (about $1.7 billion). Income from operations was $34.2 billion, up about 24%, and net income ("the bottom line") was $34.3 billion, up nearly 12%.

Profit margins

Gross margin = gross profit / revenue: 55.6% for 2019 ($90 billion / $161.9 billion), down from 56.4% (2018) and 58.9% (2017). Operating margin = operating income / revenue: 21.1% ($34.2 billion / $161.9 billion), versus 20.1% in 2018 and 23.6% in 2017. Net margin = net income / revenue: 21.2% ($34.3 billion / $161.9 billion), versus 22.4% in 2018 and 11.4% in 2017, when a larger-than-typical provision for income taxes and less other income than usual pulled it down. Operating margin can therefore give a cleaner year-to-year picture.

Earnings per share

EPS = net income / shares outstanding. The conservative approach uses diluted shares, which include shares that options, warrants and similar securities could create. Alphabet's 2019 diluted EPS was $49.16 ($34.3 billion / about 698.6 million diluted shares), a 12.5% improvement on $43.70 in 2018. Basic EPS was $49.59.

Reading Alphabet's balance sheet (year-end 2019)

Total assets were nearly $276 billion: current assets of about $152.6 billion and non-current assets of about $123.3 billion. Total liabilities were nearly $74.5 billion (current about $45.2 billion, non-current about $29.2 billion), and stockholders' equity was $201.4 billion, up from $177.6 billion (2018) and $152.5 billion (2017). Alphabet held $119.7 billion in cash, cash equivalents and marketable securities. Book value per share was about $288.37. The burn rate is how fast a money-losing organization spends its cash.

Valuation essentials

Market capitalization = share price × shares outstanding: about $934 billion (698.6 million shares × $1,337.02 on December 31, 2019). Enterprise value (EV) adds debt and subtracts cash, and represents the minimum price to acquire the whole company: nearly $806 billion. The P/E ratio = share price / EPS: $1,337.02 / $49.16 gives a trailing P/E of about 27×, and on the roughly $56 EPS analysts expect for 2021 the forward P/E is about 24×. Historical sector averages are about 20× for information technology and 16× for communication services.

Chapter 9: Corporate disclosure laws, rules and regulations

Why the rules matter

Companies cannot say whatever they want, whenever they want. Elon Musk's August 2018 "funding secured" tweet about taking Tesla private at $420 a share led to an SEC case. Musk paid a $20 million fine, stepped aside as board chair for three years and later agreed to have a securities lawyer pre-approve tweets on sensitive subjects. There are more than 450 federal agencies, including the SEC, FTC, FDA, EEOC and the Fed. The general counsel is a key partner for communicators.

Securities laws and periodic filings

The Securities Act of 1933 (the Truth in Securities Act) and the Securities Exchange Act of 1934, which created the SEC, followed insider abuses before the 1929 crash. Sarbanes–Oxley (2002) set sweeping audit rules, and Dodd–Frank (2010) overhauled financial regulation. Public companies file unaudited 10-Qs three times a year (Q1 to Q3) and an audited 10-K annual report. Material events such as mergers, bankruptcies, auditor changes or director resignations require a prompt 8-K. Information is material when there is a substantial likelihood that a reasonable investor would consider it important to an investment decision.

Regulation Fair Disclosure (Reg FD)

Adopted in August 2000, Reg FD bans selective disclosure of material information to particular investors or analysts. If a company discloses material information unintentionally, it must promptly disclose it broadly through an 8-K and/or a news release. "Promptly" means as soon as reasonably practical, but no later than 24 hours or the start of the next day's trading, whichever is later. In 2019 the SEC acted against TherapeuticsMD for alleged Reg FD violations. After Netflix CEO Reed Hastings posted a viewership milestone on his personal Facebook page in 2013, the SEC brought no enforcement action. Instead it clarified that companies may use social media for disclosure if investors are told in advance which channels will be used.

Material non-public information

Misusing material non-public information can bring fines, bans and prison, as the Mychal Kendricks and Chris Collins insider-trading cases show. Companies use pre-earnings quiet periods and insider blackout periods. Officers and directors report trades on Form 4, and investors who acquire more than 5% file a Schedule 13D (or sometimes a 13G).

Earnings calls and guidance

The quarterly earnings call, usually hosted by the CEO and CFO within about a month of quarter-end, is the centerpiece of financial communication: prepared remarks followed by analyst Q&A. Other channels include analyst/investor days, investment conferences and non-deal road shows. Earnings guidance is provided by 94% of US public companies (73.4% globally). Warren Buffett and Jamie Dimon warn that quarterly guidance fuels short-termism. The Private Securities Litigation Reform Act of 1995 helps stem the filing of frivolous or unwarranted securities lawsuits, including suits involving a public company missing a previously released forecast. Separately, whenever a public company makes a forward-looking statement, such as guidance, it should include safe harbor language, which outlines company-specific risk factors that could materially impact the firm's future financial performance.

Key takeaways

• Capital comes from retained earnings, grants, loans, bonds (debt) and stock (equity), raised and traded in the capital markets.
• Going public means an S-1 prospectus, a quiet period, a road show and a listing. Netflix sold 5.5 million shares at $15 in 2002.
• Alphabet's 2019 figures: revenue $161.9 billion, gross margin 55.6%, operating margin 21.1%, net margin 21.2%, diluted EPS $49.16, market cap about $934 billion, EV about $806 billion, trailing P/E about 27×.
• Disclosure runs on 10-Qs, 10-Ks, 8-Ks, Form 4 and 13D, and Reg FD, which requires unintentional selective disclosures to be made public within 24 hours or by the next day's opening of trading, whichever is later.