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Calculating
the Real Value of High-Tech Companies
By
Jay Hollander
Jay Hollander, Esq. is the principal of Hollander and Company LLC, www.hollanderco.com, a New York City law firm concentrating its efforts in the protection and development of property interests relating to real property, intellectual property and commercial interests, as well as related litigation.
The content of this article is intended to provide general information relating to its subject matter. Providing it does not establish any attorney-client relationship and does not constitute legal advice. Personal advice in the context of a mutually agreed attorney-client relationship should be sought about your specific circumstances. Summary: Dramatic
fluctuations in the stock prices of Internet companies
have been common. As a result, it's often very difficult
to determine the real value of those companies. This article
explains some of the problematic accounting practices and
other issues behind valuing high-tech companies.
Introduction
Ask most stock market investors with
a stake in a once high-flying tech company what the biggest
problem with their portfolio is and you'll hear the same
basic laments about valuations getting ahead of themselves.
Maybe you'll hear about stocks with great growth potential
being unfairly hit hard by forecasts of a slowing economy.
What
you won't typically hear is that maybe the companies' valuations
were based on earnings that weren't quite what the companies,
the media or the analysts reported them to be.How could
that be, you ask? How many ways are there to report income
and earnings? You'd be surprised.Increasing use of certain
accounting practices by many companies, particularly high-tech,
new-economy companies, can result in sales and earnings
figures that are easily mistaken by investors and can even
be considered inaccurate as real measures of company performance.Just
look at how wildly the prices of certain stocks have gyrated
over the last year, depending only on differences of a
penny or two in reported earnings. When every penny in
earnings counts, our grandmothers' warnings to count our
pennies take on a whole new meaning and now require that
we look more closely at how tech company earnings are calculated.Clearly,
this article is no substitute for a course in accounting,
nor is it any attempt to impugn the reputation of any company
in particular. It should, however, give you some exposure
to some of the more common ways that carefully chosen accounting
practices affect a company's reported sales and earnings
and, as a result, that company's stock price.
Problem
with Booking Revenue: Price-to-Sales Ratio
Because some
of these practices have recently begun to receive attention
with respect to new-economy companies, let's start with
an example that has been closely linked with them, particularly,
the dot-com middleman and auction-site companies. These
companies make their money by serving as middlemen for
makers and owners of products or services, taking a cut
out of every transaction that is processed over their site.
As such, their only true income is the commission they
make in the transaction.What's more, because many of these
companies have not been profitable, their stock valuation
has been measured by comparing their stock price to their
actual revenues or sales, resulting in a price-to-sales
ratio, a ratio allowing the reasonableness of the stock
price to be compared to similar companies whose stock prices
were also measured as a multiple of their reported sales.The
problem is that many of these companies have been acting,
for accounting purposes, as if they were the makers of
the products or services, and not just as brokers or commission-based
transaction facilitators.Acting this way, they booked the
costs of goods they didn't make and services they didn't
perform, while booking the sales prices of the goods or
services as their revenue. They have done this even though
the only real sales revenue kept by them was the commission
and even though their true cost of goods was minimal, if
anything.Because unprofitable companies like these didn't
have earnings, merely showing a sharp rise in the dollar
value of sales was enough to drive the stock price up dramatically,
without investors realizing that only a fraction of these
amounts actually resulted in cash to the company.If these
companies only reflected their commission revenues as their
sales, the numbers would obviously be different and the
price-to-sales valuation of the stock would be adversely
affected.
Problem with Booking Revenue: Advertising
Many
other new economy companies have relied on advertising
for the majority -- or all -- of their income, mostly in
exchange for the now ubiquitous banner ad. Many investors
have had no idea that the dollar amounts these companies
were booking as revenues were not cash revenues but, instead,
barter revenues, that is, revenues that don't involve cash.So,
an online company could make a deal with an offline company
to exchange online advertising for some other good or service,
even offline advertising itself, essentially trading exposure
in different environments. In such a trade, companies have
reported the perceived value of the advertising as revenue.
This lack of cash revenue has allowed the companies to
report only the perceived market value of goods or services,
arguably without adequate proof of the reasonableness of
the number. This trend raises important difficulties.Because
customers traditionally pay cash for advertising, attributing
a hard and fast value to any particular advertising leaves
a lot of wiggle room when no cash is actually paid. While
advertising barter is not unique to online companies, its
pervasiveness in the new economy dwarfs what existed before
the dot-com explosion, increasing the impact of any reporting
inaccuracies many fold.Second, because the real cost or
price of advertising varies dramatically based on volume
discounts and the willingness of a company to actually
pay cash in exchange for it, the potential for distortion of
revenue figures also increases.Even though recently effective
accounting standards have been put in place to require
comparable value cash transactions to justify attributed
value, these two difficulties conspire to call into question
the accuracy of claimed non-cash revenues, that, nevertheless,
have been used to buoy the sales numbers and, where available,
the earnings number of many online companies, materially
impacting their stock price.
Character of Income
Lest
you think that valuation-related accounting practice problems
are unique to dot-com companies, let's look at some problems
that affect a wider range of high-tech companies. One such
problem involves the impact of "investment" income on a
company's bottom line. As the technology bull market of
the late 1990s rumbled on, even successful technology companies
themselves took notice of the phenomenal gains to be made
by direct early-stage investment in the stock of other
potential high-flyer tech companies. Over the last few
years, the number and dollar amounts of investment by existing
technology companies in others has mattered a great deal
to the "earnings" of the companies doing the investing.Under
traditional accounting methods, investment income is supposed
to be separately accounted for and is not supposed to be
included in a company's core business earnings. The principle
behind this is pretty straightforward, as income from selling
a profitable investment doesn't say much about how a company's
business is growing. Nor is it a reliable indicator of
future earnings since such income can be a one-time event.Yet,
more and more, even well-established technology companies
began to take the position that such investments weren't
tangential investments but were strategic investments that
should be counted as part of their operations or core earnings.While
there is a difference of opinion in accounting and financial
circles on this issue, the conclusion makes a difference
because including such one-time investment gains in operational
income ratchets up earnings and estimates of future earnings
for reasons not necessarily attributable to the actual
health of the company's business.
Dilution Issues
New
economy or old economy, no company can figure out its "P/E," or
price-to-earnings ratio without two numbers other than
the stock's current price: the company's earnings and the
amount of shares outstanding. Dividing the first number
by the second gives you the earnings per share number that
is used to calculate the P/E, the fabled barometer of corporate
stock value.For high-tech companies in particular, though,
the number of shares of stock outstanding can be skewed
because of something that has been one of the main catalysts
of the technology economy: stock options.High-tech companies
have largely grown on the strength of employees who traded
large parts of their cash income for stock options, a vehicle
where an employee is given the right to buy a certain number
of shares of stock at a certain "strike" price for a certain
period of time. The employee hopes that the price of the
stock will rise over time and allow a profit equal to the
difference between the strike price and the stock's fair
market price at the time the options are cashed in or "exercised."To
be sure, options have benefits for the issuing companies
since they allow companies to spend less cash on payroll
and, in some cases, give the company a tax deduction when
the employees exercise them. Options can also be potentially
valuable to the employees if and when they become profitable.But
the problem for investors is this: Because earnings per
share are calculated based on the number of shares outstanding,
failing to count the shares indirectly represented by options
really gives only a partial view of earnings per share.
If these options were cashed in, the shares represented
by them would be included in the division leading to the
P/E ratio. In other words, these options are really dilutive
of corporate earnings per share because, ultimately, the
earnings will have to be divided among the optioned shares
when the options are exercised. Simply put, the greater
the number of shares, the less the earnings per share.While
there is an accounting category for "diluted" earnings
per share that takes factors like this into account, this
is not the earnings number that companies publicize when
their earnings are reported and such diluted earnings numbers
are not readily available to most investors unless they
studiously peruse the company's public filings for the
number of outstanding options, the company's total earnings
and outstanding shares, and then do the math themselves.
The
Evaporating "Goodwill" Expense
Now comes the real kicker.Leaving
aside the market value of a company's stock, every company
values its hard brick and mortar assets by what's called
its "book value," equal to the cost of the assets minus
any applicable depreciation. This method is used to value
office equipment, automobiles, real estate and other hard,
tangible assets.Yet companies, particularly high-tech companies,
spend fortunes developing their "intangible" assets, things
such as their brand or reputation, and the value of their
intellectual property in things such as trademarks, software,
etc. These intangible assets acquire a value over and above
the cost spent to create them because of their popularity
or public recognition and all of this accumulated positive
value is lumped together under the category of "goodwill."By
some estimates, companies today invest more in intangible
assets falling under the category of goodwill than they
do in old-fashioned brick-and-mortar assets. When companies
merge or are acquired, goodwill, therefore, represents
a sizable portion of the acquired company's assets -- sometimes
the biggest portion. Yet, certain accounting practices
have allowed companies to ignore the true acquisition cost
of these goodwill assets.This scenario usually unfolds
in the context of high-tech corporate acquisitions where
one company is acquired without cash, solely in exchange
for stock in the acquiring company. To the extent that
the assets of the acquired company include potentially
expensive goodwill, the acquiring company can currently
choose to handle the acquisition in one of two ways, either
under the "purchase method" or as a "pooling of interests."Under
the purchase method, the amount of the purchase allocated
to the acquired company's goodwill is amortized by the
acquiring company over several years as a non-cash expense,
much like depreciation. Such an expense, obviously, decreases
the company's earnings during the amortization period.But,
an accounting practice called a "pooling of interests" permits
the cost of goodwill to be ignored in an acquisition on
the theory that the assets and liabilities of the two companies
are merely being merged with no resulting goodwill created.This
perfectly legal accounting method allows acquiring companies
to avoid the goodwill expense and avoid the otherwise resulting
decrease to their earnings, arguably avoiding a fair assessment
of the true cost of the acquisition.Revised standards,
implemented by the Financial Accounting Standards Board
-- an independent organization that determines standards
for accounting and financial reporting -- had called for
the elimination of the pooling method in mid-2001. This
would have meant that companies that have met or beaten
their earnings estimates based upon income from acquired
companies, unhampered by the cost of acquired goodwill,
would be forced to recognize this cost, a cost that could
have potentially proven devastating to stock prices of
companies that otherwise narrowly beat estimates if accurately
reported. As recently reported in The Wall Street Journal,
however, intense pressure from the large high-tech companies
benefiting from this practice, as well as sympathetic congressional
representatives, has resulted in a sudden backing away
from the original version of the new requirement, instead
allowing the practice to largely continue and highlighting
the importance of the issue to investors.
Conclusion
So,
what's a poor, ordinary investor to do?First and foremost,
be careful not to blindly accept analysts' opinions or
summary reports of earnings rattled off by the media
until you know what's really being measured.Recognize that
earnings can be stated in a variety of ways, including or
excluding categories of revenue and expenses that materially
affect real core earnings and investigate accordingly.Seek
out company public filings to get the types of information,
discussed here, that are often glossed over or ignored
in mainstream financial reporting.
Changing
accounting standards, combined with increasing investor
awareness and increased scrutiny and reporting by the financial
analysis and reporting sectors may yet translate into differences
of pennies that will be worth untold dollars in the stock
market. Copyright © Jay Hollander, 2007. All Rights Reserved.
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