Financial Statements and Valuation

Are financial statements relevant anymore?  In this topsy turvy market that seems to defy gravity, I wonder.  I read this article in Marketwatch about how financial statements don’t seem to matter when it comes to stock valuation.  I am sorry, but I believe that if you run a business and COGS > Sales, you won’t have a business for very long.  I might be old school but I think a company focuses on what it measures.  It’s also important to figure out the right ways to measure it-so financial statements matter.

I do agree with the article, that accounting is stuck in the industrial age and needs to figure out the right way to measure the influence of things like intangible assets.  It’s very hard to do.  I hope the Financial Accounting Standards Board (FASB) takes a good hard look at it with lots of lively debate.

Many of the mergers and acquisitions that happen work because of GAAP accounting.  The numbers work.  That doesn’t mean it’s a good idea, or that the companies are better off merging.  It doesn’t mean shareholders are necessarily better off either.  Using financial accounting as a lens for strategy leads to bad decisions.  It’s important to use economic accounting numbers to formulate strategy.  They will often give you a different outcome.

One huge problem I have with arguments pro and con regarding government budgets is accounting numbers are always used.  That’s why if you decrease a tax, there is always a hole in the budget. Yet, any rational human knows if you decrease a tax a hurdle to economic productivity is removed and you should generate more revenue at the end of the day.  All depends on the elasticity of the activity you are taxing.

Over the course of the last ten years, I have noticed a trend.  Companies really accentuate non-GAAP (generally accepted accounting principles) earnings.  They chafe at the bit of GAAP.  There is more information in the notes than there is in the actual numbers.  You have manipulate the notes to find the true economic effect on the business.  This takes me to the point about revisiting, and issuing new standards that keep pace with the things that are important in business.

Companies execute on what they measure.  What they measure should be core to their strategy.  Everything falls in place in an organized manner when they do that.  Increasing top line revenue is the only sustainable way to increase bottom line revenue.

This topic comes up in audits of portfolio companies-and in venture portfolios.  What’s the right way to carry the value of an investment in a startup firm?  Measuring is critically important for two reasons.  One, the firm needs to attract and hire talent.  Pricing options based on valuation is one way to do it.  Price it too low, and founders give away too much equity.  Price it too high, and it’s impossible to attract good talent.  Where is that Goldilocks valuation-and how do you arrive at it?  Different accounting firms use differing methods and have differing views.

For venture capitalists, valuing portfolio companies is a hard core measurement of how they are doing as a firm.  If the value of portfolio companies go up, it should be comforting to their investors.  It should also be a signal when they try to raise another fund.

Personally, I carry the value of companies that I invested in at the negotiated term sheet regardless of how the company is doing.  It feels like the only true way.  Some accounting firms only use the initial valuation until exit.  Some try to extrapolate a valuation based on top line revenue and multiples of similar firms.  Others look at term sheets, and extrapolated valuation and split the difference. There is no real hard and fast GAAP measure.  There are some guidelines from the AICPA, but they are subject to interpretation.

A negotiated term sheet is an arms length transaction put together by independent parties.  It’s also a market based price-albeit a very illiquid market.  The true value of the company is what someone is willing to pay to own it-and often that price is different than the term sheet price.  Of course, the price is generally lower.  But, in the VC game the company can catch up to valuation.  You are betting on the promise of new technology that no one really knows the true value of.  So, you won’t find it in financial statements.