The Constant Currency Fallacy

Is your company's growth real or just an exchange rate trick? A closer look reveals that constant currency reporting can be a smokescreen, masking weak performance and potentially leading boards astray. Constant currency may promote investing in weak currencies, where returns may actually be less attractive than in stronger markets. We expose the hidden risks of relying on constant currency metrics and provide a clearer path to accurately assessing your performance across different markets.

Stakeholder: Investors

Risk: Misleading performance reporting

Management: Use the same currency (any, actually) for reports and report comparisons for the purpose of performance evaluation

An overlooked yet far-reaching problem of executive performance is currency treatment. Most large companies operate in different countries with different currencies. How can you compare the performance of these country operations, and, even more puzzling, how can you consolidate the performance into one single corporate performance? If executives do not properly examine the problem, they may arrive at misleading conclusions if they ignore the currency conversion issues discussed here. Spoiler: reporting at constant currency is not the solution.

Remember Europe at the time of multiple currencies?

Since currencies are so difficult to grasp, it helps to use a simple example. For this purpose, we go back in time when Europe had many currencies, and we imagine Peter, a Swiss farmer, who owns a field of apple trees in Basel, Switzerland, and two fierce competitors, François in Mulhouse, France, and Julia in Mühlheim, Germany, each with a field of apple trees of their own. They are not only fierce competitors, but they are also fearless and meet every January in neutral territory on the river Rhein, bordering the three countries, Switzerland, France, and Germany, to assess who did best in the previous year.

While drifting on a float in the bitter cold, they compare their numbers from the current year. Peter presents an income of 100 Swiss Francs, François made 100 French Francs, and Julia earned 100 Deutsche Mark.

As they want to know who did best, they ask themselves if their performance was actually the same. Is it? You can’t tell. First, you need to know the result of the year before to assess how good the performance in the current year actually is. Let’s say the previous year’s result was higher for Peter in Switzerland and lower for Julia in Germany. She may have done better as she grew her operation while Peter experienced a contraction in revenues. Has she? Only if they count in their respective currencies. Is it correct to compare performances across different currencies? Intuition may mislead, as it does when comparing stock returns (see the earlier contribution on intution and stock returns.

Performance at constant currency

For the evaluation of performance, let’s assume that all three had the same previous year's performance of 90, meaning that Peter, Julia, and François all grew their operation by 11%.

This is what accountants refer to as “performance at constant currency.” This means you assess your performance in the local currency. But will Peter, Julia, and François agree that they all perform the same way if the exchange rate between their currencies changes?

Let’s look at the effect of exchange rates on business performance. We start by assuming that the exchange rates in the previous year were at par. One Swiss Franc bought one Deutsche Mark or one French Franc. We further assume that the rates changed in the current year and that we report the current year with the typical exchange rates of the late nineties, where one Swiss Francs bought about two Deutsche Mark and four French Francs. These big changes make the calculations easier. The result is below:

The change in the exchange rate doesn’t affect the constant currency result above. It’s still 11% in each currency. But it does change direct comparisons in other currencies.  If we express the performance in Swiss Francs, Peter still made 100, but Julia made only 50 Swiss Francs because the 100 German Mark converted to only 50 Swiss. François did even worse at 25 Swiss Francs only. If we express the Swiss Franc changes from one year to the next, growth is 11% for Peter, -44% for Julia, and -72% for François. It looks completely different in the other currencies. In Deutsche Mark, Peter grew his operation by 122% and Julia by 11%, while François contracted by -44%. In Franch Francs, all grew; none contracted revenue.

Which currency should we use to rank the performance of the three competitors? It doesn't matter. If we want to know how Peter, François, and Julia rank against each other, they all rank the same, no matter what currency you use. Peter is always first, Julia second, and François last, no matter what currency we use. Only the performance at constant currency cannot differentiate between the three performances.

All currencies provide the same ranking. That is an important insight. We have provided a spreadsheet where you can play with the exchange rates as much as you want. You will never be able to create a situation where the rank is different in one currency from another.

The Achilles’ heel of constant currency 

Are they all wrong, and is the performance at constant currency the only correct one? Many managers assume that constant currency performance gives you the right result. But that is only true if there is no trade across borders. If there is trade, and there certainly is trade in apples between Basel, Mulhouse, and Mühlheim, each just an hour apart, then the prices for apples need to be more or less the same in each currency. If they were not the same, apples would leave the country where the apples are cheap and enter the market where they are expensive. In other words, Peter, François, and Julia cannot have much different prices for their apples when converted to the other currencies.

For simplicity reasons, we start with a price of one Swiss Franc, that is, one Deutsche Mark in Germany and one French Franc in France in the previous period. Let’s keep that price fixed in Swiss Franc and assume that the apple still costs one Swiss Franc in the current period (again, you can play with different assumptions in the spreadsheet provided). Competition forces the prices in the other markets to be at the same level. Since Deutsche Mark and French Francs depreciated, the price in Germany went up to two Deutsche Mark, which is still only one Swiss Franc in the current period. The apples in France now cost 4 French Francs:

What does this mean for management performance? If apple prices are the same in Switzerland, France, and Germany, Peter in Switzerland did better than the year before, Julia did worse, and François did the worst. Just look at the numbers: Peter gets 1 Swiss Franc for each apple. He must have sold 90 apples the previous year to reach a revenue of 90 and 100 apples in the current year to reach a revenue of 100 Swiss Francs. If the prices for apples are the same, Julia sold her apples at 1 Deutsche Mark in Germany, which equaled one Swiss Franc in Switzerland in the previous year. Julia sold 90 apples to reach her result of 90 Deutsche Marks in the previous year and sold only 50 apples in the current year at a price of 2 Deutsche Marks to reach her result of 100 Deutsche Marks, a drop of -44%. François in Mulhouse did even worse. In the previous year, he sold apples at one French Francs, the equivalent of one Swiss Franc, and now sells them at four French Francs because they are one Swiss Francs in Switzerland, and the exchange rate is four French Francs to the Swiss Franc. François achieved the result of 90 French Francs by selling 90 apples in the previous year and now only sold 25 apples to get to a result of 100 French Francs in the current period, a decrease of -72%.

We can rank the performance again, this time by the number of apples sold. The ranking result is the same in all currencies. Peter, Julia, François. The only statement useless to assess the performance of Peter, François, and Julia is the performance at constant currency. Why, then, you may ask, is constant currency so popular? This question can be answered by turning Peter, Julia, and François into segment heads of a conglomerate we call Tripatriate Holding.

The Tripatriate Holding

Let’s assume Tripatriate Holdings owns all three operations. Peter is your head of Switzerland, Julia of Germany, and François of France. How would you consolidate their performance? If Tripatriate reports in Swiss Franc, it would report revenues of 175 (90 Swiss Francs from Switzerland, 50 Swiss Francs from Germany, and 25 Swiss Francs from France (see first table above). 

If Tripatriate were headquartered in Germany, it would report 200 Deutsche Mark from Peter, 100 from Julia, and 50 from François, a total of 350 Deutsche Mark. In France, it would report a result of 700 French Francs. Three different values for the exact same operation. This means Tripatriate looks good in Germany, as it grew 30%, and even better in France, as it grew 159% in French Franc. It only looks bad in Switzerland: Reporting in Swiss currency, the company contracted by -35%.

If you compare the reporting results in the different currencies, who will not be happy? Probably the Swiss, as it is the only result that looks bad. The Swiss may prefer to report in constant currencies, which looks better. The Swiss report may state prominently that the operation grew at 11% in constant currencies, despite the fact that it did not grow at all, in none of the currencies and also not in the volume of apples sold.

Constant currency favors weak currency markets

That is exactly what happens in the real world. Companies headquartered in strong currencies put a lot more emphasis on their constant currency result. Should you use it? There is no advantage in using constant currency for performance comparisons, as you may suspect by now, having looked at the tables above. But there is more. We have provided the example of a hypothetical ABB and Siemens conglomerate in the spreadsheet, which operates in just two markets, Swiss Francs and the Eurozone. In the sheet you can see that any ranking at constant currency is the same as the ranking by single currency. This means that constant currency provides no advantage for performance rankings relative to others.

The only difference between a real-world currency, such as the Swiss Franc, Euro, or Dollar, and a constant currency is that the latter rewards managers who grow in weak currencies and, therefore, provides an incentive to operate in weaker currencies. But that is not at all in the company's interest.

How would you, as a board member of Tripatriate, want to assess the performance of Peter, François, and Julia? Definitely not in constant currency. Constant currency promotes business in weak currencies, which is of no interest to either the company or the investors.

What boards should do with currencies

When boards look at performance reports, they should not accept reports at constant currency. They should ask their CFO office to provide the following:

• Convert the performance into one currency; any currency will do, even Bitcoins. They will all show the same performance ranking.
• Share this article and the spreadsheet with your colleagues to understand that constant currency provides misleading information.

Boards can do even more:

• Learn why the Total Shareholder Return metric has to be in the same currency for all peers (spreadsheet, lines 10 to 39). Read our Blog on why intuition may be wrong when it comes to stock returns.
• Learn why only a single currency gives the right picture and why reports using different currencies are useless for comparing businesses (spreadsheet, lines 40 to 84).
• Learn why only businesses in strong currencies like to examine their performance at constant currency and all others prefer the real currencies (spreadsheet, lines 85 to 93).
• Learn why constant currency does not provide additional insights in conglomerates operating in multiple currencies as a ranking based on constant currency will always provide the same rank order as a ranking in a single currency, making statements at constant currency dispensable (spreadsheet, lines 94 to 169).

Don’t be fooled by constant currency. It is misleading and only used to hide the weaker operations. If your team insists, let them do a report at constant currency AND at constant prices. You will get a more real picture, and they may grow.