The most valuable asset of your company is missing, what’s next?

Growing your business means more than managing your accounting books.

Doing business is getting more and more complex as we begin to realise that the profit or loss and net assets are no longer reflective of the real value of business. The argument that financial statements is not reflective of a company’s financial wellness is now getting a much bigger blow with recent publications stating that only 20% of a company’s actual value is reflected in the balance sheet. This is an alarming statement but needs to be understood more by the public before panicking.

The missing eighty percent

Where did the 80% go? There’s a wild speculation out in the market by various journalists and researchers indicating that the value might be attributable to ‘human capital’, unrecognised brand name values, carbon efficiency, culture, or other intangibles which are currently not capitalisable under accounting standards. While the 80% figure seems to be finger in the air, this argument holds true when tested.

Intangible assets that are internally generated, such as brand names and contact lists, are not allowed to be capitalised under current accounting standards. A general concept is that these intangibles are disallowed because the cost incurred to generate these intangible assets are not identifiable. Just imagine the trade name Jolibee®, it costed nothing to Jolibee Food Corporation other than to register the brand with the Department of Trade and Industry and Securities and Exchange Commission of the Philippines, yet the name itself is much more valuable than the physical assets of the company.

Once the business is sold to a third party, accounting standards would then allow the purchase price to be allocated to these intangible assets since the acquirer paid good money to acquire primarily the ‘brand name’ and the ‘established processes’ of acquiree rather than physical assets. The purchase price in a business purchase transaction is a highly complex accounting and valuation exercise, the general principle is that the valuator (usually a third party expert in transaction diligence) will use specific business valuation methodologies to value the business as a whole. The purchase price would then be allocated to the identifiable net assets of the acquiree with the excess allocated to separately identifiable intangible assets and goodwill.

Testing the hypothesis

I have been curious for a bit of time whether the pareto split of 80–20 is factual since it came as a surprise to me to realise that accounting books is just a slice of cake. Since my own investigation is not for academic purpose, I followed a practical approach to test whether this assertion is factual.

Rather than testing the fair value of the business which would take so much time to construct a working business valuation model, I used the 2015 acquisition information which removes valuation ambiguity related to assumptions used in the business valuation.

Limitation/s:

Analysed companies are limited to the two listed telco (instead of all three listed telcos) in the Philippines (i.e., Globe and PLDT) since the market capitalisation of Liberty is insignificant compared to the other two.

Methodology:

1. Extracted relevant 2015 business combination information from published financial statements
2. Intangible assets and goodwill recognised as a result of the business combination are summed in ‘Total Intangibles’ column
3. Fair value of net assets is based on the disclosed amount excluding the recognised intangible assets and goodwill
4. Percentage of the business acquired represented by intangible assets is determined as a percentage of the total net assets after the business combination (fair value of net assets and total intangibles)
5. Total intangible assets recognised out of negative net assets is assumed to be 100%

Source:

a. Globe Telecom, Inc. http://static.globe.com.ph.s3.amazonaws.com/GLOBE%20AR%202015%20financial.pdf`
b. Philippine Long Distance Telephone Company
http://pldt.com/docs/default-source/annual-reports/2015/pldt-2015ar_financial-section.pdf?sfvrsn=2
Table 1 — Summary financial information

Intangible assets acquired by Globe from BTI are related to the customer contracts, franchise and license held by BTI (see Note 8 to the financial statements). What is interesting here is the amount related to goodwill. Goodwill is an interesting account in the financial statements which represents anything that cannot be quantified individually and is measured as the residual amount after allocating the purchase price to the fair value of the net assets.

Based on this simple test performed, it appears strikingly factual that intangible assets represents more than 80% of a company’s value. It is incredible to see how much your business is actually worth if you have to consider these items floating in the air.

Why it’s missing

To make sense of the intangibles of a company, it would be good to revisit how the intangibles are actually computed. The graph below summarises the distribution of the purchase price assuming an 80–20 distribution:

Fig 1 — Split of purchase price between tangibles and intangibles

The purchase price determined by the valuator is generally determined based on a discounted cash flow model which assumes includes various discrete and non-discrete assumptions about the company’s future cash flow. The cash flow model follows the accounting standards which can either be based on the acquiree’s free cash flow, excess earnings, distributable reserves or other methods as appropriate. Effectively, the purchase price is actually the corporate value of a business at a point in time.

Understanding how the purchase price is determined is helpful in understanding why there is a significant gap between the company’s balance sheet and the corporate value. The balance sheet accounts for historical transaction and allows only the recognition of actual events which have an exact (or almost) value, this avoids the risks that fraud will be perpetuated in the recognition of bogus assets. The corporate value takes into account the future performance of the company, economies of scale, process efficiencies and future harmonies between the acquirer and the acquiree amongst others. While balance sheet provides an accurate picture at a point in time, the corporate value represents the saleable value of the business. The gap between the balance sheet and the saleable value is then the so-called intangibles that we’ve discussed earlier.

Overall, what drives the business value of a company can be attributable to three key intangible items: (1) people; (2) culture; and (3) process. These three drivers together allows the company to run on autopilot and create future financial value for the business.

What’s next?

Understanding how this works is crucial for the long-term success of your business. Without a viable business and good process at the back end, the corporate value can either be equal or less than the balance sheet value of your business. Understanding how corporate value works can provide substantial leverage in business planning whatever stage you are.

A start-up would need to understand that business plans are not just about financials anymore. It is important that you start your business with a plan in mind to align your financial goals with the company’s vision and to work on long-term investments which would allow better organic growth of the business.

An established business would need to revisit how much catch-up they need to do to redirect efforts on placing more focus on developing their people and establishing a culture of trust. Businesses that projects too much financial focus will lose their people and create a culture of fraud and distrust.

Before closing off this lengthy post, it is important that business owners be more comfortable working with financial concepts. Business valuation is a rather niche market until today even in matured markets such as here in the United Kingdom, more so in the Philippines where business valuations are mostly done in preparation for public offers or merger and acquisition transaction. However, there are simple approaches that business can do to determine and monitor their corporate values through business model templates. Understanding is the first step, curiosity is next.