I have been studying up the British company Legal @ General for a possible investment. It provides retirement solutions and asset management services, mostly in UK and also life insurance brokerage in US. It likes to compare itself to US companies like BAM and BLK and say it is significantly undervalued. One of the things management touts is its 20% ROE. I found the following exchange in earnings call for 2021 results.
</>Q: you’ve flagged the 20%-plus ROEs on an IFRS basis. If you, do it on own funds, I think the return is more like 10% to 12%. Could you just give us some thoughts around the differential there?
A: Return on own funds, well, it’s another metric. I mean, it’s another way of looking at the business. Clearly, we can’t really compare like-for-like at this stage and there’s a difference in the metrics. New business being an obvious one. For example, one gives you a profit on IFRS, one is strain and Solvency II then comes out over time.
THis is what I found in the notes to the annual report: ROE is calculated as IFRS profit after tax divided by average IFRS shareholders’ funds (by reference to opening and closing shareholders’ funds as provided in the IFRS consolidated statement of changes in equity for the year). Closest IFRS measure Calculated using: - Profit attributable to equity holders - Equity attributable to owners of the parent
I have no idea about the intricacies of IFRS accounting and how it differs from GAAP accounting. Management’s response too was vague and didn’t really answer the question.
Can someone explain this issue of ROE being vastly different in IFRS and GAAP and why?
Thanks.
I’m not too familiar with the finer points of GAAP, but one huge difference that I know quite well is that IFRS allows companies to use market value when valuing assets whereas GAAP often doesn’t.
Under GAAP, the balance sheet value of real estate is purchase price (plus associated costs) plus the cost of improvements minus accumulated depreciation.
Under IFRS you can use market value, even if this is just an specialist’s estimate.
So under IFRS movements in the market value of real estate appear directly in the profit & loss account. Whereas under GAAP changes in market value are ignored, unless the property is sold when the difference in GAAP accounting value and the sale price is crystallised in the accounts.
One area where this is really noticeable is property companies. Here in Britain, the net asset value of the company’s properties is published in the accounts and changes appear in the profit & loss account. Under GAAP market values are ignored.
This means that a company can have post two very different profits, one using GAAP accounting and the other using IFRS.
I much prefer IFRS because it takes account of market value whereas GAAP pretends that market value doesn’t exist. If nothing else, IFRS makes valuing property companies much easier!
One thing to add regarding Legal & General is how profits are booked for life assurance (and annuity) business. I’m a but rusty, having retired from the industry almost 20 years ago back when Legal & General was a composite insurer (life and non-life insurance).
I believe that British life assurance companies, when they write a piece of life assurance policy can record the estimated profits over the expected lifetime of the policy in the current tax year, rather than accruing them over the actual lifetime of the policy. This brings future profits forward into the current year thus increasing that year’s profits at the expense of future years’ profits.
Under IFRS you can use market value, even if this is just an specialist’s estimate.
Though not wrong, the way you’re phrasing it there, it makes GAAP sound more sensible and useful.
Not the usual viewpoint : )
GAAP is somewhat more often based on market values or cost basis, depending on how things are held. Both can be crazy.
IFRS, for many things, is based on value estimates based on observable metrics like cash flow yield.
For a lot of asset classes, like real estate, that is a far far better way to assess the likely true value of something.
Separately—
Whether the value estimates flow through to the profit and loss statement each period is a separate issue, and not really a problem for anyone paying attention.
If you’re looking at a security best valued on assets, you know enough to look at the assets rather than the current period’s volatile reported earnings.
Whether it’s British Land or Berkshire Hathaway.
Berkshire was both: until recent GAAP accounting changes all the big mark-to-market asset value swings showed up in the “other comprehensive income” line, not the P&L.
Now those are all in the net profit line, so net profit now goes up and down like a &%&^%(*&. (beloved off-colour simile no longer polite)
But for anyone watching book, there has been no change.
Is there good news with the change?
The headline EPS averaged over long periods now matches the increase in book per share, which is good and sensible and wasn’t the case before.
But EPS is now so volatile that by the time you get a time interval long enough to get a stable smoothed average metric,
the company size and structure isn’t the same as it was in the interval average date so the smoothed value still isn’t meaningful.
Can’t win! At least with EPS.