The stock exchanges report the price that a willing buyer and willing seller agree upon for a share of a publicly traded stock. In most cases, the buyer and the seller are unaware of each other's identities, and the desire to buy or sell can stem from many scenarios. For this article, let's assume the transaction was not required, and the valuation was based on the underlying company's fundamentals.
This fundamental value is based on assessing a multitude of financial evaluations. The information needed to value a company is stated in its financial statements. The Balance Sheet, with the assistance of introductory algebra, provides the value of the “Owners' Equity.” In short, owners' equity is the value of their Total Assets minus their Total Liabilities.
What goes on the balance sheet is not in question. The assets' value, however, on the balance sheet is often in question. The secondary market offers a clear-cut price for steel or even a fully assembled automobile, but what is a patent, company brand, or software program worth? How quickly can that value change?
The technology boom impacted the balance sheets just like the stock markets. According to the Ocean Tomo Intangible Asset Market Value Study, intangible assets as a percentage of assets on the balance sheet have grown from 17% in 1975 to 90% in 2020. The largest growth was between 1985 at 32%, rising to 68% of the value by 1995.
Value is in the eye of the beholder, and balance sheets are no different. CFOs (Chief Financial Officers) defend their valuations for assets listed on their balance sheet, but not everyone may agree with the declared values. “Defending a balance sheet to financial analysts is its form of art,” says Adam Harter, CFA, Chief Investment Officer at the Financial Enhancement Group.
“When you make a fundamental evaluation of a company, you need accurate financial data and need to decipher between fiction and reality. The leaders of a company have a natural bias to believe their assets are worth more rather than less,” per Harter.
Common mistakes in the balance sheet come from missing transactions or not coding them correctly, omitting transactions altogether, forgetting inventory changes, and inconsistency. These challenges are likely for smaller companies or struggling enterprises, but the themes are familiar for even the most prominent companies – think Enron.
The challenge for investors in the change from tangible to intangible is noteworthy. Tangible assets are easy to value and insurable. Intangible assets are challenging to value and difficult to insure. How many parts on a car – think carburetor – were patented and had sizable value worth far less today? How should an investor plan for remarkable bursts in value for new drugs and technology while simultaneously preparing for the immediate obsolescence of a highly valued software program?
Investing isn't for the weak at heart. The process is fluid and requires a watchful eye for proper understanding.
The Financial Enhancement Group is an SEC Registered Investment Advisor. Securities offered through World Equity Group, Inc. Member FINRA/SIPC. Advisory services can be provided by Financial Enhancement Group (FEG) or World Equity Group. FEG and World Equity Group are separately owned and operated.