Balance Sheet Is Not Equal to Value
It’s natural that business owners keep tabs on the value of their companies. In most cases, the company is the owner’s most valuable asset—one he or she hopes to sell for a healthy price at some point in the future.
Where do owners look for clues about value? They often start with financial statements. For example, it would seem reasonable to look at the assets on one side of the balance sheet and subtract the liabilities on the other, with the result being something akin to the value of the equity in the business—a bit like a house with a mortgage. Unfortunately, that’s typically not how it works.
That’s because the balance sheet only reflects the historical amount invested in the business. It’s a rough proxy for the fair market value in an orderly liquidation—the value of a business if it sold its tangible assets, paid off its debts, and shut down.
What the balance sheet doesn’t show is the return on that investment. The return is reflected in goodwill and intangible assets such as brands, customer lists, and proprietary technology.
Accounting rules say these assets generally can’t be recorded, which is unfortunate because they represent the vast majority of many companies’ value. In fact, according to Ocean Tomo, well over 80 percent of the components of S&P 500 companies’ market values is represented by these types of intangibles, which means it is not reflected on the books. This is a lot of value that’s invisible on companies’ balance sheets.
With this in mind when contemplating value, it’s helpful to incorporate all the assets—including the intangibles—and consider a “valuation balance sheet,” which would look forward to the business’s expected future returns. This type of exercise would more accurately point toward the company’s value as a going concern.