Time Since Acquisition
Financial statements are historical documents that show what a company looked like at one point in time in the past. The problem with this historical perspective is that markets, investors, and ownership are constantly changing. When a long time has passed since the acquisition of an asset, chances are there will be large differences between what the books say the asset is worth and what that asset is worth in the market.
Suppose a company purchases a new machine to use for normal operations in manufacturing some product. The asset is recorded by the company’s accountants at the cost of the asset at the time of purchase. However, the value of this asset will not remain constant over time. The more time that passes increases the chance that there will be a large discrepancy between how the books value the asset and what the asset could sell for in the market.
If two companies buy the same new machine at a cost of $100,000, then according to GAAP both companies will record the asset with a value of $100,000 on their books; both machines will have a book value of $100,000. However, suppose company A uses the machine 24 hours a day and company B only uses it 8 hours a day.
The wear on company A’s machine will be much greater thereby reducing its value much more quickly than company B. At the end of 5 years, both companies have depreciated the value of the machine down to $1,000; both machines now have a book value of $1,000. An investor looking at the assets of both companies might conclude that the value of both machines is the same. However, since company B’s machine is in much better shape than company A’s, the market value of the two machines is quite different. Were each company to sell their respective machines in the market, company B would realize a much higher price than company A.
The problem with book value of assets is that they do not reflect the actual value of something; corporations are required to record assets in a uniform manner and the book value is the fairest record. This can be a problem for long-term assets such as investments in other companies. Because of the tax-timing option for capital gains, the book value of shares of stock of another company sits on the books at the book value, the value for which they were purchased. Should the value of the company’s stock increase over time, the value of the asset remains hidden until the shares of stock are sold and an actual cash flow is realized.
The difference between the book value and the market value of an asset can make it difficult for an investor to properly value a firm. Since financial statements are historical documents, more than just the numbers given to an investor should be evaluated. It is possible for companies to appear more or less valuable than financial statements indicate. Wise investors are aware of this discrepancy and learn to dig deeper into the asset holdings of a potential investment.