SAMIZDAT

Feast:

Ca

JackL.Treynor
Feathered Feast is a case about disclosure-about the relation between
the reporting accountant and the
outside user and about the framework within which these professionals performmutuallycomplementary
roles. Likeall cases, it conferslittle or
no insight on those who merely read
it. Rather, one has to live the
case-to feel the frustrationand anguish of the protagonist, Shepard
Saunders.
Background readings for Feathered Feast include "The Trouble
With Earnings" (FinancialAnalysts
Journal, September/October 1972)
and "A Hard Look at Traditional
Disclosure" (FinancialAnalysts Journal, January/February1993).

Feadwed Feas Inc ()

In May 1993, Shepard Saunders,
manager of the Amalgamated Iceman's Pension Fund, was reviewing
certainpurchases that, in retrospect,
had not worked out as successfully
as he had originally hoped. Among
these was FeatheredFeast, Inc., purchased for the fund in December
1991.'
Feathered Feast, Inc. (FF) was at
that time one of a number of rapidly
growing fast-food chains specializing
in fried chicken. FF was distinguished by the fact that, instead of
selling franchises, it retained complete control of all FF retail outlets,
owning them outright. Management
argued that outrightownership gave
them better control over the quality
of the final product. But outright
ownership, together with management's effort to keep pace with its

rapidly growing competition, had

also led to a heavy demand for
funds.
Despite FF's rapid growth, its
management had controlled costs
very successfully, maintainingprofit
marginsvirtuallyconstantuntil 1992.
In order to conserve funds, management had subcontracted the warehousing, distribution and foodpreparation functions. New funds
were mainly used for the construction of new outlets, which were built
on leased land.
Each outlet was basically a standardized, sheet-metal structurefabricated in the shape of a giant
chicken, with integral refrigeration,
deep-fry vats and warming ovens.
Standing nearly 30-feet high, these
structuresserved to excite the eating
public's interest in FF's principal
product, the Featherburger. They
were, in fact, rapidly becoming a
familiarsight along heavily traveled
suburbanarterieswhen fast-food retailing marginscollapsed in 1992.
The shock and disappointmentof
FF shareholders was heightened by
the fact that, until that time, FF's
profitperformancehad been spectacular (see Table 1). It was, in fact, the
profit performancethat had induced
Shepard Saunders to "swing a little
bit," as the institutional salesman
from the FirstHoboken Corporation

had put it, cashing in Treasurybills

amounting to roughly 5% of the
fund's portfolio and devoting the
proceeds to FF shares.
The salesman from First Hoboken
had explained why FeatheredFeast,
selling at 40 times earnings, was a
bargain:Since the company, with its
aggressive merchandisingand innovative product concept, had burst
onto the fast-food service scene in
1987, earnings had grown steadily at
10%per year (see Table 1). The performance was all the more impressive because, as the First Hoboken
research report had made clear, the
quality of earnings was high. The
growth was entirely genuine, internal, organic growth, unadulterated
by "dirty pooling" acquisitions.
There were no franchisecontractsto
be taken into sales at inflatedfigures.
Depreciation was conservative: The
retail structures were fully depreciated in 12 years on a straight-line
basis, despite the fact that, with
proper maintenance, they would
easily last 40 or 50 years.
In view of this rapid yet steady
growth, coupled with the demonstrably high quality of earnings, a
discount rate (total return) of 12%
was surely conservative. Feathered
Feast had consistently succeeded in
paying out over 85% of its earnings
in dividends, and it had achieved

Table1. Foresight
Depreciation
andPft A
in000,000)
(dollars

Net Income (aftertaxes)

Net Income Plus Depreciation
Dividends
JackL. Treynoris President of TreynorCapi- CapitalInvestment
tal Management, Inc. in Palos VerdesEstates, Gross Plant
California, and a member of the Editorial Dividends/NetIncome
Board of this journal.

FinancialAnalysts Joumal / November-December 1993

ysisforFaedFeast

1987

1988

1989

1990

1991
(est.)

$ 58
$100
$ 50
$$500
0.86

64
110
55
50
550
0.86

71
121
60
55
605
0.85

78
133
67
60
665
0.86

85
146
73
67
732
0.86

The CFA Institute

is collaborating with JSTOR to digitize, preserve, and extend access to
Financial Analysts Journal

www.jstor.org

this high dividend payout without

borrowingto finance its rapid expansion. Using the famous GordonShapiro formula to translate these
assumptions about growth rate, discount rate and dividend payout rate
into an estimate of the investment
value of Feathered Feast (see Table
2), the salesman had argued that
FeatheredFeast was worth at least a
price/earningsratio of 43, in contrast
to the ratio of 40, at which it was
selling in December of 1991.2 Although Saunders had never entirely
bought the salesman'sargumentthat
these achievements made Feathered
Feast the "bluest of the blue chips,"
he had been preparedto believe that
it was a far sounder investment than
many of the "story stocks" that
lacked its tangible assets and record
of solid earnings growth.
Shepard Saunders' first inkling
that all was not well with FF came
when he read in the WallStreetJournalthat FFwas defaultingon some of
the lease contracts for retail sites
(these contracts had 12 years' duration, with subsequent options to renew). Declining unit volume and
cut-throatprice cuttingquicklytransformed formerly profitable outlets
into money losers. The problem,
which appeared first in California
and then spread across the country,
was-at least in hindsight-clearly
excess capacity. At the end of 1992,
Table 2

most of FF'sretailoutlets were barely

covering out-of-pocketcosts of operation. Unable to cover corporate
overhead costs, FF auctioned off its
assets for scrap value.
Although most of FF'scompetition
had encountered the same problem
at aboutthe same time, it was hardto
understandhow a companythat sold
at 40 times earnings one year could
be broke the next. In his attempt to
understandwhy FeatheredFeasthad
been such a disappointment, Saunders developed the figures shown in
Table 3. He noted that, by 1992,
Feathered Feast's existing outlets,
being scarcely able to cover out-ofpocket operating costs, were essentially worthless. That meant, he reasoned, that the outlets that came into
operation at the beginning of 1987
had, at least in hindsight, a five-year
economic life. In similar fashion, he
reasoned that the outlets that went
into operation in 1988 had a fouryear economic life, and so forth. Using these new assumptionsabout the
economic lives of units coming into
operation in each of the years from
1987through 1991,Saundersrecalculated earningsafterdepreciation(see
Table 3).
When depreciation was adjusted
with the benefit of hindsight, Feathered Feast still displayed a rapid
earnings growth rate-but the earnings and the growth were negative.

's Estimat of the InvesmentValueofFe

(year-end1991)
BasicAssumptions
Five-YearGrowth Rate (see Table 1)
Discount Rate

10%
12%

DividendPayoutDetail
Depreciation(12 years, straight-line)
Earningsafter Depreciation
Cash Investment
Cash Availablefor Dividends
Dividends/Earnings

5/12 of gross
7/12 of gross
6/12 of gross
6/12 of gross
6/7 of net

Note:The Gordon-ShapiroFormulais:
Price/Earnings
Ratio=

DividendPayoutFraction
DiscountRate - GrowthRate
6/7
0.12 - 0.10

=-

10

0.86
= 43.0
0.02 -

If Table 3 rather than Table 1 represented the true eamings history for
FeatheredFeast, Saundersreasoned,
then it had not been worth 43 times
1991 earnings (estimated)in December 1991. But it had not been until
1992 when fast-food margins collapsed, that it became clear that Table 3 was a better representationof
the earnings history than Table 1.
Perhaps Saunders was misusing
historicalearnings data. Perhaps he
didn't understand what the data
meant. He decided to go to a wellrecognized accountant, someone
who had given a lot of thought to the
objectivesof financialstatementsand
the conceptual framework for accounting. The obvious choice was
the noted accounting theorist, Stamford Ridges. Saunderswas delighted
when Ridges granted him an interview. A transcriptof Saunders'questions and Ridges' answers follows.
Saunders:Was I wrong to rely on
the earnings history of Feathered
Feast in estimating the value of its
common stock?
Ridges:Eamings for an enterprise
for a period measured by accrual
accounting are generally considered
to be the most relevant indicator of
relativesuccess or failureof the earnings process of an enterprise in
bringing in needed cash. Measures
of periodic earnings are widely used
by investors, creditors, security analysts and others.3
Saunders:Is it appropriate to extrapolate historical earnings trends
into the future?
Ridges:The most importantsingle
factor determining a stock's value is
now held to be the indicated future
earning power-that is, the estimated average earnings for a future
span of years. Intrinsicvalue would
then be found by firstforecastingthis
earning power and then multiplying
that prediction by an appropriate
"capitalization factor." "Earning
power" means the long-termaverage
ability of an enterprise to produce
earningsand is estimatedby normalizing or averaging reported earnings
and projecting the resulting trend
into the future.
Saunders:My experience with
Feathered Feast suggests that earn-

FinancialAnalysts Joumal / November-December 1993

TOIe

a Hindsight
De

000,000)
(dollars

m"
o andPflt Ana ISfor Feat ed Feast
1991

1987

1988

1989

1990

(est.)

Gross Plant
New Investment
RestatedDepreciation

$500
$$100

550
50
112

605
55
131

665
60
161

732
67
228

Net Plant
Net Income (aftertaxes
plus depreciation)
Depreciation

$400
$100

338
110

262
121

161
133

0
146

$100

112

131

161

228

$ 0

(2)

(10)

(28)

(82)

Net Income

ings, earningstrend and estimates of

investment value based on these
numbers can be very sensitive to the
life of fixed assets.
Ridges:Assets are not inherently
tangible or physical. An asset is an
economic quantum. It may be attached to or represented by some
physical object, or it may not. One of
the common mistakes we all tend to
make is that of attributingtoo much
significanceto the molecularconcept
of property. A brick wall is nothing
but mud on edge if its capacity to
render economic service has disappeared; the molecules are still there,
and the wall may be as solid as ever,
but the value has gone.
Saunders:So it's the economic,
rather than the physical, life that
matters. How is the outside user to
know whether reportedearnings are
true earnings and reported earnings
trend true trend unless he knows the
economic life of majorassets?
Ridges:The success or failure of a
business enterprise's efforts to earn
more cash than it spends on resources can be known with certainty
only when the enterprise is liquidated.
Saunders:How, then, does the accountant arrive at the figures he reports?
Ridges:In the purest, or ideal,
form of accrual accounting, sometimes called direct valuation, each
noncash asset represents expected
future cash receiptsand each liability
represents expected future cash outlays.
Saunders:Wouldn't I be better off
if I focused on financial data that

were untaintedby the subjectivityof

an accountant'sexpectations?
Ridges:The standard of verifiability is a necessaryattributeof accounting information, allowing persons
who have neither access to the underlying recordsnor the competence
to audit them to rely on those
records.
Saunders:If I wanted to base my
analysis on numbers relatively free
fromthe influence of an accountant's
expectations regarding the future,
what numbers might I use?
Ridges:The fundamental concern
of investors and creditors with an
enterprise's cash flows might suggest that financial statements that
report cash receipts and cash disbursementsof an enterpriseduring a
period would provide the most useful informationfor investorand creditor analyses. That information is
readily available,can be reportedon
a timely basis at minimum cost, and
is essentially factual because it involves a minimum of judgment and
assumption.
Saunders:Would you mind telling
me again why outside users like myself are supposed to pay so much
attention to earnings?
Ridges:The relation between cash
flows to an enterpriseand the market
price of its securities, especially that
of common stock, is complex, and
there are significant gaps in the
knowledge of how the marketdetermines the prices of individual securities. Moreover, the prices of individual securities are affected by
numerous other factors that affect
market prices in general. Neverthe-

FinancialAnalysts Journal/ November-December 1993

less, the expected cash inflows to the

enterpriseare the ultimate source of
value for its securities, and major
changes in expectations about these
cash inflows immediatelyaffectmarket prices significantly.
Instrinsic value is the value that
the security ought to have and will
have when other investors have the
same insight and knowledge as the
analyst. Because the intrinsic value
of a stock usually cannot be measured directly, given the uncertainty
of its future cash dividends and market prices, investors and securityanalysts commonly attempt to estimate
it indirectlyor to estimate some surrogate for intrinsic value, such as
what a stock's price ought to be in a
price/earnings ratio. The procedure
involves estimatingaverageearnings
for a future span of years-the indicated future average earning power-and multiplying that prediction
by an appropriate"capitalization"to
obtain intrinsic value. For example,
estimatedaverageearningsper share
may be multiplied by a price/earnings ratio to obtain a price that reflects intrinsic value. If that price is
higher than the market price, the
analysis advises the investor to buy;
if it is less than the marketprice, the
analysis advises the investor to sell.
Saunders:So that's why you accountants place heavy emphasis on
reported earnings.
Ridges:Decisions about what information should be included in financial statements and what information should be excluded or
summarized should depend primarily on what is relevant to investors'
and creditors'decisions.
Sensing that he had gone about as
faras he could go with Ridges, Saunders thanked him and brought the
interview to a close. Although he
found Ridges' answers enigmatic
and mildly confusing, he had the
feeling that they held the key to his
problems with FeatheredFeast.
In a few days, Saunders would be
meeting with the trustees of the
Amalgamated Iceman's Pension
Fund to explain its investment performance since 1991. They had selected him to manage the portfolio

11

3. Does Table 1 present a true 2. ProfessorsGordonand Shapiroare the

authors of a widely used formula acearnings picture for FeatheredFeast?
cording to which the appropriate
4. In terms of the information
price/earnings ratio for a common
available in December 1991, was
stock is equal to the proportion of
FeatheredFeast a growth company?
earningspaid out in dividends divided
5. What information available in
by the appropriate discount rate (or
December 1991 should Saunders
total return) minus the expected
have relied on in his assessment of
growth rate.
the investment worth of Feathered
3. All of Ridges' answers are excerpted,
Feast?

largely because of his reputation for

emphasizing tangible earning assets,
rather than "stories." He was sure
the trustees would ask him to defend
the Feathered Feast decision and to
explain the subsequent investment
disappointment. Should he show
them Tables 1 and 2? Or should he
show them Table 3? Saunders was
uncertain exactly what to say.

Qesons
1. What accounts for the difference
between the earnings pictures presented in Tables 1 and 3?
Footnotes
2. Was the earnings history of
Feathered Feast as presented in Ta- 1. FeatheredFeast is a case preparedby
JackTreynor.
ble 1 really history?

into

insight

New

out of context and with malice aforethought, from two documents-Tentaon Objectives
tiveConclusions
of Financial
Statementsof Business Enterprisesand
(the discussion memorandum)Conceptual Framework
for FinancialAccounting
and Reporting,published December 2,
1976, by the Financial Accounting
StandardsBoard.

derIvatives

How can you effectively manage interest-rate risk? What are the risks of mortgage-backed securities?
Financial Derivatives contains 16 in-depth articles, written by Federal Reserve Bank of Atlanta
economists, that provide answers to these and many more questions about futures, options, and swaps.
To order,enclose your name, address

AnessIentialtoolfor:

and a check or money order

payable to
FederalReserve Bank of Atlanta,or
~~~~~~the
include your Visa or Mastercardnumber,
and mail to:

Analysts
Financial
Financial
Analvstso
CommercialBankers
InvestmentAnalysts
Portfolio Managers

Business Professors
0

FinanIc

FederalReserve Bank of Atlanta

Public Affairs Department
|

al

Derivatives

New Instruments and Their Uses

104 Marietta Street, N.W.

Atlanta,GA 30303-2713
For more information,call:
(404) 521-8020

This valuable 242-page reference is only $15, including shipping and handling.

12

1993
FinancialAnalystsJoumal/ November-December