What do the following films have in common: Spider-Man (2002), Men in Black (1997) and Return of the Jedi (1983)?
I’ll give you a clue. Spider-Man took in $826m at the box office against a budget of $139m. Men in Black took in $589m against a budget of $90m. And Return of the Jedi took in $483m against a budget of $33m.
Have you worked it out yet? Yes, that’s right: none of these films ever made a profit. Anyway, moving on…
Royalty payments
Hang on! What’s that you say? How can I claim that none of these films ever made a profit when in each case their box-office takings dwarfed their production costs?
Well, if you don’t believe me, let’s ask some of the people whose royalty payments were dependent on these profits. In 2002, Spider-Man creator Stan Lee sued Marvel after the company claimed it received no profits from the film as defined by the terms in his contract.
In 2019, Men in Black screenwriter Ed Solomon referred to the film’s profit statement as “the greatest work of science fiction I have ever been involved with” after it claimed it was still in the red, 22 years after it was released.
And in 2009, the actor David Prowse – Darth Vader himself – told Equity magazine: “I get these occasional letters from Lucasfilm saying ‘we regret to inform you that as Return of the Jedi has never gone into profit, we've got nothing to send you’.”
So what is going on?
Welcome to the world of ‘Hollywood accounting’, where the lawyers and bookkeepers at the major studios and production companies use every trick at their disposal to avoid paying out royalties to the people involved in making their films.
But rather than go into detail about how profits can be understated to confuse actors, writers and directors, we’d rather talk about how profits can be overstated to confuse investors. Because we see it all the time.
Profits are not a statement of fact
Profits are often considered to be a statement of fact rather than a matter of opinion. This is not the case. When something is quantified, people tend to give it more credence. Compare the statements “it was 27oC” to “it was a warm day”. Most people are inclined to give greater weight to the former than the latter (clearly an opinion). Although profits are presented as a specific number, in reality they are a culmination of many opinions.
For example, if a customer has yet to pay for a service it has received, the company that provided this service is allowed to recognise the debt in its profits by reflecting the difference in working capital. When times are tough, customers may be encouraged to ‘buy now, pay later’ (which does not affect profits) rather than demand a discount (which does). Again, the difference is reflected in working capital.
Alternatively, imagine you’re a technology company employing developers to work on a new software release. As they are employees of the company, you would expect their salaries to be a ‘cost’ that hits profits. However, companies have the option to ‘capitalise’ some of these costs – put them onto the balance sheet. Then, when the software is released, they can amortise (gradually write off) the cost of these salaries against sales of the product over its lifetime, thereby deferring the hit to profits.
This can make a substantial difference to adjusted earnings and therefore P/E ratios. For advocates of EBITDA (which we are not) it’s even better – these costs never hit this metric.
Another issue is the use of ‘adjusting items’, which allow companies to ignore ‘non-recurring’ costs when reporting profits. The problem here lies with the definition of ‘non-recurring’ and often sees the day-to-day costs of running a business treated as one-offs and removed from the profit-and-loss statement. A large redundancy may be a legitimate one-off, but what if redundancies happen every year?
A focus on cashflows
So, what can investors do to protect themselves? One method of identifying the sort of practices mentioned above is to focus on cashflows – the amount of money coming in and going out of a business.
While not an exact comparison, think of the Hollywood films mentioned at the start of the article and how the difference between box-office takings and production costs didn’t translate into profits – when a company’s cashflow statement looks substantially different from its reported earnings, that immediately makes us suspicious.
Not foolproof
This technique doesn’t always work. Often there’s a credible explanation for why the numbers are different (and it’s worth noting that all the practices mentioned above are completely legitimate). In the past, focusing too heavily on cashflows has caused us to sell out of some companies we should have kept hold of and to miss other opportunities entirely.
And while it can help us steer clear of frauds, it isn’t foolproof: we didn’t pick up on what was going on at Patisserie Valerie, for example, as its profits and cashflows looked immaculate. In that case we were plain lucky – the shares looked too expensive for us, so we never invested.
But over the years, managing money in this way has repeatedly helped protect our investors from share prices falls when companies are struggling. Just as importantly, we have found that a predictable and growing cashflow that is allowed to compound over the long term is an underappreciated driver of returns, allowing us to take full advantage of the small-cap effect.
You can forget about Spider-Man, Darth Vader and everyone else in Hollywood for that matter – to us, cashflow is the real superstar.
William Tamworth is co-manager of the Artemis UK Smaller Companies fund and the Artemis UK Future Leaders investment trust. The views expressed above should not be taken as investment advice.