Question

How is it possible for a young business to experience growth, and increasing share prices while their profits are simulatneously suffering from cannibalization? How/where do a firm's financial statements justify this disconnect?

Answer 1

Valuations and share prices, though impacted by the current performance of an enterprise, are also significantly impacted by the future expectations of performance by the entity.

In the initial years, businesses having good prospects may entail lower profits, or even losses as the operations are set up. However, in many businesses where the business model is perceived to be strong and having a bright future, investors see this as an opportunity to enter early as a shareholder thereby, pushing the demand and the share price upwards.

Also, from a financial statements perspective, a lot of time, entities in the start up phase invest a lot in creating of Intellectual property or other intangible assets. These intangible assets, based on the accounting requirements, need not necessarily be capitalised in the books of accounts. These may be fully written off, thereby, making a dent in the profits and net worth. However, if the IP or intangible asset is successfully deployed, the entity may have a significant quantum of cash flows, with no or a very small vaue asset in ther balance sheet. Therefore, this is an element, along with may other costs which are relevant to start up (eg. huge marketing costs, where benefits may be obtained over a span of 3 or 5 years but need to be expensed off as per accounting requirements) need to be analysed in detail to understand the disconnect between performance of the entity and share prices.

This is a topic of huge discussion and debate. For any further discussion or clarificaitions, please comment