A slippery slope

by Matthew Henry via Stocksnap
by Matthew Henry via Stocksnap

I never expected to get riled up over accounting.

Alexandra Scaggs in the FT this morning expertly dissects a paper in the CFA Institute’s Financial Analysts Journal, in which the authors claim that profits are no longer important in company valuations.

As an ex-investment analyst, this is befuddling. I used to be pretty damn good at financial models, all of which were based on earnings projections. And as an entrepreneur, I cared a lot about cash flow.

However, times have changed. The stock prices of Amazon and Tesla do not reflect earnings forecasts (which no-one really has a clue about, anyway) – their price/earnings ratios are crazy. And yet, that does not mean that they are bad investments (this is not professional advice!).

This disconnect could well be why so few tech companies are going public – that, and the relative ease with which they can come by funding through other methods.

I have been getting increasingly concerned about the accounting standards for initial coin offerings (ICOs), and will wail about them more in another post.

But for now, let’s focus on asset value.

Research and development (R&D) costs are considered “expenses”, and hit the bottom line. Capital outlays and acquisition costs are considered “investment” and can be capitalized and amortized over time. So, it makes more sense (from an accounting point of view) to buy a research company than to do it yourself.

But then, assuming you consolidate the figures, and assuming your new R&D team keeps at it, you’re back to having high costs relative to the growth in assets.

Again, this could partially explain why tech companies are increasingly realising that IPOs are not for them.

ICOs, on the other hand… No-one seems to care about fundamentals such as future earnings there.

And in a free market, that is the investors’ choice. But it does represent a fundamental shift from the value-creating roots of corporate participation, which we should be aware of.

We also need to contemplate the long-term impact that this shift could have. When we focus on speculative gain (as with most of the ICO market today), we don’t really care what the company does, or how. We care about how “cool” it is, how “hot” the topic. We veer towards an alarmingly short-term bias which will, if it persists and spreads, affect the investment decisions of the companies themselves.

An economy focused on short-term deliverables and market appeal will become more volatile. This will give speculation a veneer of common sense. And, let’s go big here, possibly undermine the very essence of capitalism.

We need to think about that.

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