Calculating a Company's Total Value
The historical information found on a corporation’s financial statements represents only the company’s financial position at some time in the past. No matter how strict accounting practices were adhered to, they can never fully represent the actual value of the firm and its components. Investors trying to place a value on a firm must be aware and take into account the discrepancies between what a firm is worth on paper and what is really worth in the market.
Suppose a company buys an asset and records its value according to Generally Accepted Accounting Principles as the total amount of money paid for the asset. Essentially, the book value of the asset is the price paid and using a depreciation schedule, the asset will lose value over time until it reaches the end of the schedule and the asset is no longer counted as an asset on the company’s books. This procedure may be a fair way to value an asset from an accounting point of view but the reality is that there can be major discrepancies between book value and market values.
The total value of a corporation is the sum of the market values of its assets. However, financial statements only report book values. The longer an asset is held, the greater the chance that the book value of an asset differs from its market value. These values can also diverge because of other economic issues outside the control of the corporation. Given this information, it is clear that the total value of a firm should never be estimated as the total value of the book values of its assets found on the firm’s financial statements.
Recall that the balance sheet identity is given as:
Assets = Liabilities + Owners’ Equity
Also recall that the balance sheet identity can be rewritten to more easily illustrate the relationship between the equity of investors and the financial decisions made by managers as:
Owners’ Equity = Assets – Liabilities
From this rewritten identity it is plain to see the residual nature of stockholders’ equity as the difference between what a firm owns (assets) and its contractual obligations (liabilities). In essence, the owners’ equity figure is nothing more than a plug number to make the identity “work." However, since the figures from this equation are derived from book values off the balance sheet, the owners’ equity figure is no more accurate a measure of market value than the book values of the assets and liabilities.
If the market values of a firm’s assets and liabilities could be easily confirmed, then the residual, which represents the value of stockholders, would be an accurate measure of a firm’s value. The lack of accurate market values makes investors seek other methods of determining the total value of a corporation.
The best estimate of a firm’s value is based on stock price for which shares of the company are selling in a stock market. In fact, a very accurate measure is to simply find the product of the price of a share of stock and the number of shares outstanding. This value takes into account more than just the book values of a firm; it includes market, economic, and currency conditions. The stock price of a firm will fluctuate to account for new information, such as the decisions of the company’s managers.
Since the book values found on a firm’s financial statements provide an inaccurate measure of a corporation’s value, investors look for estimates of the firm’s market values of both assets and liabilities. The best estimate of a company’s worth can be found in its stock price which is influenced by all available information affecting the firm. Using this information, investors can also better estimate the market values of both assets and liabilities to obtain a more complete picture of a company’s health and future profitability.