As investors, we rely on a company's financial statements to provide us with an accurate view of its financial position because it is impossible for us to evaluate the business' financials ourselves. This is why, over the years, various rules and regulations have been introduced for public companies to adhere to when reporting figures. They are designed to minimize the risk that investors will be misled and the company will manipulate numbers to its advantage.
Granted, these rules have not eliminated all of the issues. There are still plenty of companies out there that have a reputation for manipulating numbers to the limits of legality, but for the most part, figures are relatively trustworthy (in the interest of keeping a margin of safety, I would never declare any company's numbers to be 100% accurate.)
But what if financial statements don't work anymore? This is an observation Professor Baruch Lev (the author of "The End of Accounting"), as well as Professors Govindarajan, Rajgopal and Srivastava, have made when looking at modern tech companies.
The key takeaway from the findings of these researchers is that "earnings explains only 2.4% of the variation in stock returns for a 21st-century company — which means that almost 98% of the variation in companies’ annual stock returns are not explained by their annual earnings."
The above is a revealing statement because it throws into doubt the academic research into the performance of investment styles such as value investing, which have been published over the past few decades.
Indeed, if a company's financials no longer have an impact on stock performance, does that mean that stocks trading at a low valuation compared to their financials will no longer outperform?
You could argue that this is the case. The bulk of research on value investing was conducted during the second half of the last century when the balance sheet meant something. In "The End of Accounting," professor Lev found that variations in financial metrics like earnings and book value explained 90% of the variations in stock prices for companies that came public between 1950 and 1959, but since the year 2000, variations in financial metrics explain less than 20% of the variations in stock prices for companies that have gone public.
In a recent article in the Harvard Investment Review, Professors Govindarajan, Rajgopal and Srivastava argued that the reason why balance sheets now no longer influence stock prices is that there's so much hidden value off the balance sheet. For tech companies, this is especially true.
For an industrial company, the balance sheet presents a reasonable picture of productive assets and the income statement gives a good idea of how productive those assets are, and a company's competitive advantage as expressed in profit margins.
In comparison, digital companies don't have significant hard assets; their building blocks are research and development, brands, software and client relationships. These assets are not capitalized, they are reflected as expenses, so the more the company invests, the higher its losses become, but the faster it should grow over the long term.
Amazon (AMZN, Financial) is the perfect example. The firm's size and dominance of the retail market should mean it's generating outsized profits, but because it reinvests so much back into the business, profits are elusive. How do you value this spending?
Put simply, now more than ever before it is vital for investors to know and understand what they are investing in, and how companies are spending to drive growth in the years ahead. If you cannot value a business on its balance sheet assets, but have to value the company based on what it has spent to grow its business, you need to know that this spending was worthwhile and has generated a return, either through customer retention or reputation building.
Uber is an interesting example. This company has spent billions building its presence in markets around the world. However, the reputational damage the company has suffered over the past few years has undone a lot of this work. How do you value the reputation the company has built, and more to the point, how do you value the reputation the company has lost?
In this age of tech, it has never been more important for investors to understand the companies they are backing and what assets they have, whether tangible or intangible.
Disclosure: The author owns no stock mentioned.