I was listening to the corporate finance lectures from Professor Aswath Damodaran. He was discussing the accounting controversy related to the movie Forrest Gump. The professor always comes up with such anecdotes and is surely one of the best professors in the world. You can listen to his corporate finance lectures from here and equity valuation lectures from here. These lectures will help you a lot in understanding the corporate finance and equity valuation concepts of CFA level II curriculum.
Forrest Gump was the fastest grossing Paramount film to pass $100 million, $200 million, and $300 million in box office receipts (at the time of its release). It took only 66 days to surpass $250 million and became one of the highest-grossing movies of all time. The movie was based on the book Forrest Gump authored by Winston Groom. The author was contracted by the Paramount group for the screenplay rights for his book for $350,000 and for a 3 percent share of the firm’s net profits. Winston found the deal attractive and agreed for it.
Now the movie went to production and then to distributors. It was an instant hit. Winston was on cloud nine after hearing the success stories of the movie. He was thinking about the profits that he would get. He kept on waiting for the cheque for weeks. But the cheque didn’t come. He thought that maybe they lost his address. So he called Paramount and asked them: “Where is my 3% share?” They replied: “3% of what?” He said: “3% of the accounting profits of the movie.” [The contract was such that he had to receive 3% of the accounting profit and the accounting profit was based on the studio accounting practice]. They replied that they are not making any money but are losing money. He asked that how can you guys be losing money on this movie as it has grossed more than $200 million in revenues. They asked him to come and take a look at their accounting books.
He went to their office to have a look at the accounting books and found out that they were making $80 million loss. So he looked down at the expense items and he noticed a big expense item of $140 million. He asked them about that. They said that they haven’t named that yet but that’s a provision. He asked provision for what? They replied that provision for future bad movies. [The studio accounting allows a movie company to make a portion of the revenue of a movie and set it aside as the provision for the future bad movies.]
Winston Groom said that it’s not fair and decided to contest it in the court. The case lasted only 15 minutes. The judge took a look at the contract and asked: “Mr. Groom, is this the contract you signed?” He replied yes. The judge said: “So basically you put your faith in the hands of the accountant? Is that right?” He said: “I guess so.” The judge said: “The case dismissed. You got what you deserved.” This is what happens when you put your faith in the accounting profit.
Do you know what Steven Spielberg‘s contract specifies as a percentage of? Movie ticket receipts. He gets his percentage share when the ticket gets sold and after that, the movie company can do with the revenue whatever they want to do. That’s why he ended up with billions of dollars in his bank account while Winston Groom couldn’t.
The lessons learned from this incident can be applied in every field of valuation. Rather than looking at the accounting profit, we should look at the cash flows. Accounting profit can be easily distorted by the accountants. For the matter of fact, the accountants tend to spend all their energy in doing that only. The cash flows are there for the real and are very hard to manipulate.
The returns should be based on the magnitude of the cash flows that you make on the investment. They should reflect how much you are making on the cash flow and also when you will get those cash flow. The earlier the better. Winston Groom learned that he should look at the cash flows which is the real money rather than the artificial cooked up accounting income. The famous dialogue from the movie Jerry Maguire captures it beautifully: Show me the money.
This is a very important lesson for future analysts. Never ever trust accounting income and always look at the cash flows whenever you are valuing some company or doing some kind of financial analysis on some company.
Professor Damodaran tells many anecdotes like that during his lectures to bring the concepts home. I hope that this would inspire you guys to go through his lectures and learn a lot of new things which would be beneficial for CFA exams as well.