Why a Firms Market Value Differs From Its Book Value - Essay Example

How many information bearing upon performance evaluation help to explain why a firm’s market value differs from its book value? The disparity between a firms market value and book value can cause cruicial effects. Normally, the value of a firms equity determined by the market should go in parity with the value from accounting records or book value. But practically, there may be evident disparities between market value and book value and this situation raises the questions of why these differences occur. The role of book values of companies is losing its importance as it tend to be usually lower than market value. The approach taken for accounting is past-oriented from the market value which denotes mostly the companies earnings and hence the difference. This occurs because for evaluation of the real value of a company it takes into consideration its earnings measured in money as well as other intangible and tangible assets etc., also unlike the market valuation. There are many evaluation methods followed and the most relevant of them are the evaluation based on the Economic Value Added (EVA) which is Net Operating Profit Minus Adjusted Taxes reduced by (Invested Capital*Cost of Capital). This method takes into account the opportunity costs of capital. EVA too suffers from the drawbacks as from accounting. Another theory, Shareholder value theory suggests that through the interests of the stake holders, the shareholder value can be reaped. This is for ensuring return satisfaction to all the interested parties in the long run. The stakeholder theory aims at a collective interest of all stakeholders or sees the realization of their goals as the ultimate objective. Double value creation system is also followed where a company increases its customer value through its operations as well as creates its shareholder value through the sale of its produce. Thus, it could be noted that the company value could be increased only if both the shareholders and stakeholders interest are considered simultaneously while doing the performance evaluation. Performance evaluation (shareholder): - AROCE -AE= AROCE * CSE Where, AROCE is the Abnormal Return on Common shareholders equity/Capital Employed; AE is the Abnormal Earnings and CSE is the Common Stockholders Equity. Present Value of Abnormal Earnings (PVAE), which will be available with the Present Value of Expected Dividends (PVED) and Abnormal Earnings based on Capital Employed, states the value in efficient markets as: MVE = CSE + PVAE This results in the distortions or disparity between the MVE and the CSE (market value and book value) and the conditions for this are (i) Economic rents (unbiased accounting) (ii) Accounting distortions (Perfectly competitive equilibrium) Thus, the information bearing upon the performance evaluation of a company helps in explaining the reason for the difference between the market value and the book value. Ideally, it could be inferred that the most important things to be considered in value creation processes are: • The Performance evaluation should be able to provide information for proper decision-making and ensure feedback. • The kind and nature of the information collected and the source from which the information is collected for valuations are therefore significant. The source, its nature, the methods used for valuation, the coherency, the adaptability with the strategic objectives etc serve as crucial indicators. Discuss the relevance of financial information in the context of the valuation of internet stocks. The main characteristics of internet stocks are that they are younger, fast-growing, riskier and larger when compared to the non-internet stocks. Nevertheless, the capital requirements of internet companies are very high. They need capital to establish the technological architecture, create a pool of customer base, and also have to spend a major portion on the sides of Research and Development, Marketing etc. On contrary, the internet firms have poor accounting back ups when compared to the other non-internet business and have an impact when it enters the stock market. Unlike the non-internet stocks the internet stocks have more or less nothing to claim from the financial information or from the analysis of accounting statements. As the industry and firms with the internet stocks are young, they suffer from negative earnings and cash flows. They also do not have historical data unlike other stocks to calculate required projections and to estimate the future profitability. Since the internet industry is growing in a rapid pace the available current information also remains with less help for forecasts due to heavy fluctuations. It have been observed by analysts and academics that the evaluation of internet stocks are quite difficult. Also it have been observed by (Rajgopal, Kotha and Venkatachalam, 2000) that the financial information is only of minimum use in valuing the internet stocks. Evidence derived from (Trueman, Wong and Zang) states that there is no significant relation between the net income and the value of the internet stocks. They observed that the internet stock value is more associated with the gross profits than the net income. The studies prove 52 percent variation caused by internet stock value while analysing the net income. Their evidence also supports the fact that non-financial information such as pages views (Web traffic/clicks per page) proves significant and highly relevant for internet stock valuation. The adjusted regression R2 shows an increase shift from 52 to 65 percent when click per page is considered for deriving the net income. Other observations in this regard claim, “Reach” (the limit to which an internet dirm succeeds in attracting unique visitors), “Stickiness” (states the measure of the duration spend on the site by a visitor and the average number of pages viewed) and “Cashburn” (the amount of cash burned up or spent for realizing future profits), and” Customer Loyalty” (based mainly on the average number of visits to the website per unique visitor per period) as the factors evidently associated with the value of internet stocks. However, traffic does not supply predictive information about future estimates once the historical data or the past revenues are accounted for. The value-relevance of web site traffic does not confine its role merely as a predictor of future sales but also have other significant uses as well. The stock market uses the site-traffic as a tool to measure the web businesses' ability to create ‘network effects’. When the value of a website to a visitor depends on the previous number of visits to that site, ‘network effects’ occur. Thus, it could be observed that financial information has only minimum relevance in the valuation of internet stocks. References (other than guidelines) http://www.acumenenterprise.com/Marketing/How_may_information_bearing_upon_performance_evaluation_help_to_explain_L19418/ Criticism of accounting information http://www.uni-miskolc.hu/uni/res/kozlemenyek/2005/pdf/horvath.doc Read More