In a perfectively rational world, the market value of a company would be based strictly on the financial statements. The financial statements provide a look at the profitability, cash flow, assets, and liabilities of the organization. By reviewing the current financial documents along with variances from historical information, the investor decides on value based on the cash flow of the business. The income statement provides a roadmap of the company’s revenue and expenses. The balance sheet provides a picture of the assets and liabilities of the company, and just as important, shows a glimpse into the company’s liquidity and ability to generate the cash required to pay the liabilities as they come due.
Finance professionals and investors are accustomed to the quantifiable results provided by standard financial reporting. This reporting is specific, measurable, and can be compared across companies in the same industry. However, this is just the starting point for determining the business valuation. A complete valuation will include perceptions from the analyst and the individual investor based on their view of the company. Determinations will be made on the validity of the data and the confidence in the company’s ability to maintain the general financial trend. This valuation will encompass biases that are affected by both internal and external factors.
The internal factors that affect the analyst’s perception include the management team, new product launches, and other competitive factors. The makeup of the management team can play a large role in the valuation of the company. For example, having a well-known CEO who has a documented history of leading successful business organizations will have a positive impact on the company valuation that may differ from the measurable financial results. Tesla CEO Elon Musk is an example. His past success at Zip2 and PayPal is a factor in the valuation of his current entrepreneurial endeavors. Tesla enjoys an inflated business valuation that exceeds the value that would be expected based solely on the current financial results (Butler, 2019). A skilled executive such as Elon Musk can manipulate the valuation of the company by generating positive publicity and exhibiting a confident persona. Information that is put out by Musk is seen as more believable and reliable than information from his distractors. Author David McRaney refers to this as the argument from authority (McRaney, 2011, pg. 93). Because of the status of Musk and his involvement with the company, it is perceived that his information is more credible. Sometimes this may be true, but other times it will not.
Eternal factors that influence valuation include societal and demographic changes, elections that predicate changes in the political and regulatory environment, and the behavior of competitors. These factors are not always specific and measurable. The analyst will have to determine how this will impact the company based on their individual bias. The most common example of this is the United States presidential elections. The financial markets will move based on the perceived front-runner and the anticipated policy changes the candidate is expected to enact. This may impact specific industries differently.
The challenges in determining a company valuation are what make it difficult to consistently beat the market averages. Researching a company’s financial results is the first step in the evaluation of a business. This must be followed up by gaining an understanding of the political and societal environments that which the business operates to get a true picture of the company.
References
McRaney, M. (2011). You are not so smart. New York, NY Avery
Butler, D. (2019, January 30). Tesla’s earnings don’t validate its market value: the numbers just don’t add up for this stock. Retrieved from https://realmoney.thestreet.com/investing/tesla-earnings-do-not-validate-its-market-value-14851100.