Only 20% of business value is seen in balance sheets. Here’s where the rest goes

Photo credit: Chris Pastrick.

Doing business is becoming more complex as we begin to realize that the profit or loss and net assets are no longer reflective of the real value of a business. The argument that financial statements are not reflective of a company’s financial well being is now getting much more backing with recent publications stating that only 20 percent of a company’s actual value is reflected in the balance sheet. This is an alarming statement but the public needs to understand this more before panicking.

The missing 80 percent

Where did the 80 percent go? There’s wild speculation out in the market indicating that the value might be attributed to “human capital,” unrecognized brand name values, carbon efficiency, culture, or other intangibles which currently cannot be capitalized under accounting standards. While the 80 percent figure seems to be a finger in the air, this argument holds true when tested.

Again, intangible assets that are internally generated, such as brand names and contact lists, are not allowed to be capitalized under current accounting standards. This is because the cost incurred to generate them are unidentifiable. For example, the trade name Jolibee® in the Philippines costs nothing to Jolibee Food Corporation other than to register the brand with the Department of Trade and Industry and the 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 the acquiree rather than the physical assets.

The purchase price in a business 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 while whether the Pareto split of 80-20 is factual since it came as a surprise to me to realize that accounting books is just a slice of the 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 2015 acquisition information which removes valuation ambiguity related to assumptions used in the business valuation.

Limitation

The companies that I analyzed are limited to two listed telcos in the Philippines (i.e., Globe and PLDT), since the market capitalization of Liberty is insignificant compared to the other two.

Methodology

• Extracted relevant 2015 business combination information from published financial statements
• Intangible assets and goodwill were recognized as a result of the business combination are summed in Total Intangibles column
• The fair value of net assets was based on the disclosed amount excluding the recognized intangible assets and goodwill
• The percentage of the business acquired represented by intangible assets was determined as a percentage of the total net assets after the business combination (fair value of net assets and total intangibles)
• Total intangible assets recognized out of negative net assets was assumed to be 100 percent

Sources

Financial statements of:

Why it’s missing

What’s next?

In closing