Question

Prepare a report explaining the problem of using a firm’s performance as a way of determining its value. Also list and explain the reasons the best performing companies may not be the most “valuable”.

Answer 1

Over the years, business houses have rapidly evolved and profit margins for companies have soared. Thanks to the digital revolution, globalization and easy availability of resources and capital, companies have continued to reach out to more and more customers and have maximized their overall profits.

The aim of the case study is to draw a comparison between performance and value of a company and has been described in detail as follows:-

A company’s performance indicates how it is doing over a period of time. This may reflect upon expanding business operations, earning higher profit margins and increasing the overall production. When we look at performance of a company we look at things such as increase in volume of sales, production capacity, demand for products and service among other measures.

The difference between growth and value are the elements of debt and future growth possibilities. A company that uses an old technology but is still growing in performance is most likely to face an identity crisis in the future. Further it is seen in companies that their tendency to borrow funds from various sources of credit increases over a period of time and even if profits and performance is increasing over a period of time, the actual value of the company may remain stagnant.

Value of a company is generally measured by calculating what assets a firm has and then deducting this with the value of its liability. On the other hand performance is measured on a month on month or year on year basis with the increase in sales.

Therefore in any industry, we need to look at multiple elements when assessing value and performance. Some of the key reasons why a high performing company may not be high in value are as follows.

(1) New Entrant:-

When we look at performance we always look at relative numbers. The profit margins or increase in sales of a new company would always be high. This is because at times the level of competition is relatively lower for a new industry or the net sales growth will relatively be higher when we compare from a very small number. This however does not translate into value of a firm as the company may not have sufficient assets.

(2) Exposure to Credit:-

Some companies may be selling good in markets but they tend to have high credit exposure which limits their valuation. Companies such as Kingfisher Airlines were one of the highest profit making and growing companies in the industry. Yet their valuation remained poor primarily because of their high exposure to credit.

(3) Threat from new technology:-

The effect of new technology takes time to reflect in a company’s growth. Companies that tend to adopt same old methods of doing business often find growth being relatively stable over a couple of months/years and their valuation begins declining since they sell their products at a cheaper rate to stay in competition. Over a period however lack of innovation significantly reduces the value.