Think about investor needs and decision-making
Published: 12 October 2023
4 minute read
Boards and management understand their business and its value drivers in depth. While the legislation, standards and guidance underpinning reporting requirements aim to meet a broad range of user needs, most reporting is subject to materiality.
To communicate clearly and compellingly, boards and management have to apply judgement and determine what information is material for reporting. Information is typically understood to be material when omitting, misstating, or obscuring it could be reasonably expected to influence investor decision-making.
IFRS Practice Statement 2: Making Materiality Judgements
"When assessing whether information is material to the financial statements, an entity applies judgement to decide whether the information could reasonably be expected to influence decisions that primary users make on the basis of those financial statements. When applying such judgement, the entity considers both its specific circumstances and how the information provided in the financial statements responds to the information needs of primary users."
Materiality, therefore, means considering not only what is important to the business, but also the information investors need for decision-making. While investors and their needs are not homogeneous, they do share a similar objective—to make a return on their investment.
We spoke with investors to understand commonalities in evaluating investment decisions and what information they need. Understanding the questions and topics investors consider can help companies better assess what information is material. This is not an exhaustive list of topics but rather focuses on some of the key areas of interest.
Common questions investors ask
How does this business generate value?
"I want to understand what’s material in the context of the business model – what different factors are important for it."
Investors told us that understanding the mechanics of a business is crucial, especially when making an initial investment. They look for a clearly articulated business model to answer:
- What does this business make or do? What are its key products and/or services?
- How does it generate and preserve value? How does it manage its cash flows?
- Where does it operate and who are its key customers?
- Who are its key suppliers and where are they located?
- What is its competitive advantage? How does it compare to competitors?
- How is it currently doing? Which metrics and KPIs are used to measure success? Do they seem sensible?
- Is the business model consistent with the segmental financial disclosures?
"What’s often missing is an explanation of what the business actually does and how it makes money. Sometimes for a simple business, you can work it out – but for others it’s really opaque and no effort is made."
Getting business model disclosures right is key for investors. Investors told us that a properly articulated business model can enhance their valuation of a company. Where business models are poorly explained or inconsistent with financial disclosures, investors question – is this simply poorly communicated or, more worryingly, indicative of a failure by management to understand the business?
The FRC Lab is working on a project on business model-focused reporting – this is planned for publication in late 2023.
What is the future strategy?
"We’re looking to understand the long-term value drivers and the strategy behind them. How the company will take advantage of it and what makes them unique."
Understanding the board and management’s strategy for the future is key for forecasting future returns. While not expecting companies to disclose commercial secrets, investors want to get a sense of:
- What new products and/or services is the company developing?
- How will the company grow in the future? Do they have plans to enter new markets or acquire other businesses?
- How much does the company plan to invest back in the business, for example through research and development or purchase of new assets?
"Where companies can improve reporting is on strategy – sustainability strategy could be integrated into the business strategy."
Investors value holistic discussions of future plans, considering business strategy, financial performance and sustainability in an integrated and connected manner. They noted sustainability-related factors are intertwined in the business, its operations and finances.
What potential risks are there?
"I want to understand what’s keeping the directors awake at night. If it’s not keeping them awake, why are they reporting it?"
Risks likewise impact the likelihood of future returns, making the board and management’s plans to mitigate them key for investors. Investors think about the following questions when making investment decisions:
- What would impact the cost of capital?
- What risks could break a company? For example, what would put working capital at risk? How much headroom does the company have? Which risks are most likely to emerge?
- How do these risks connect or interrelate?
- How is management horizon scanning for emerging risks?
- What mitigation plans are in place?
- Has management considered how risks interlink holistically?
Risk reporting should be specific and link to the business model and value drivers. Reporting should also be focused; investors tell us that when companies include too many risks, it raises concerns about management’s focus, as well as resource allocation.
"Companies are now seeing higher costs of capital because of low ESG scores. Anything that impacts the cost of capital is material, you can’t ignore it."
How do investors evaluate and use information in ARAs?
Information in ARAs plays a crucial role in helping investors to evaluate the potential investment opportunity. They use this information to:
Challenge their own assumptions
- How consistent is reporting with their own understanding of the business and wider sources of information?
- Do the numbers match the narrative?
- Was anything unusual or surprising?
Understand and assess the board and management’s plans, performance and stewardship.
- Do plans seem credible?
- Do they have an authentic sense of how the board and management will run the company?
- Are resources being used effectively? Is management spread thin?
Evaluate how the company performance compares to peers and competitors.
- How does it compare on key metrics, including both financial and sustainability-related measures?
- How does its balance sheet and financing contrast to others?
Reduce the universe of companies to a more manageable size:
- Does this company match their (or their client’s) investment strategy, values or objectives?
- Does anything worry them? Do they trust management and the board?
Build and challenge valuations:
- How much is this company worth?
- Are there potential activities that could reduce or increase its future cost of capital?
"When I look at an annual report, I start by thinking – what would I expect to see? Do I understand the business correctly?"
By considering the questions investors generally consider and how they evaluate and use information, management and the board can better understand what is likely to impact their decision-making. This can be an input into management and the board’s overall assessment of what’s material for reporting.
This is part two of a four-part series Applying a materiality mindset.