What financial valuations get wrong about businesses

We live in a time when metrics and data have been elevated to God-like status. Financial valuation has become a catch-all formula for determining a company's value. But that figure only tells part of the story.

In terms of market capitalization, JP Morgan Chase is today worth around a third as much as Amazon. Is Amazon really three times as good as Chase? When you add up the value of each company's shares, that's how it shakes out, but this metric tells you nothing about the internal structure and underlining health of these companies – the special sauce that defines each business' identity.

Our existing, myopic financial valuation system that hinges on market cap does not consider the passion of a company's employees, the sense of loyalty from its customers, its dedication to research and development, or its ability to withstand bubbles and recessions.

For private companies, the barometer for value is even more limited: A company is only worth what somebody is willing to pay for it. Businesses can have immense benefit beyond their financial incentive to prospective buyers and investors, and in some cases, it can have less. How much stock should we put into financial valuations? How should a business leverage what it likes about itself into its globally perceived value? 

The value of culture

One example of a company with a transcendent culture is the Japanese numerical control (NC) equipment manufacturer Fanuc. When the company was founded in 1956, Japan's NC industry was non-existent. Under the leadership of Seiuemon Inaba, a young executive engineer and one of Fanuc's first 500 employees, the company has become a global leader in robotics. By 1982, Fanuc had already captured half of the world's NC market.

Despite pressure to move to the United States, the company has remained in Japan, where its factories, assembly lines, and even its workers' jumpsuits are all colored an electric yellow. One third of Fanuc's workforce is engaged in research and development, which further contributes to an overall sense of belonging for Fanuc employees. The sense of fulfillment experienced by employees is a very real thing. In my mind, by keeping Inabu in a leadership role for over half a century and by engaging employees in the future of the business, Fanuc's actual worth and global standing are much greater than any financial valuation could ever predict.

So what do I think a company or asset should be worth? That depends on how well a company conveys its story and the veracity of its conviction. If you let the market or analysts or public opinion decide what your company's strengths and weaknesses are, you've lost the ability to tell your own story and defend your decisions. 

I remember when Yahoo was valued at over $100 billion in 1999. Seventeen years later, it was acquired for around $4 billion. Yahoo's excessive valuation was a reflection of blind optimism in the industry at that time, but it would never have been so high had people taken a closer look at more intangible qualities about the business – the skill-level of its employees, the strength of its leadership, the health of its corporate culture, its creativity and innovative spirit, etc. The company lost agency in deciding how it was valued and why it was important. 

What about private companies?

Fanuc and Yahoo are public companies, and as such their price-per-share is a simple – and largely inadequate – method of determining their worth. What about a private company? Annual revenue is one way to pin down a private business' value, but again, it's only one slice of the pie.

Private companies are better situated to withstand seismic changes in the market – the 2000 dot-com crash and the 2008 recession being worst-case scenarios. (Look what happened to Yahoo, mostly sold at discount to Verizon). 

Nonetheless, remaining private opens a company up to potentially catastrophic internal failures caused by bad decision-making at the top. I have seen it happen many times over the course of my career. To roundly understand any business and thereby get in front of any issues, you have to consider who works there, how long they've worked there, and what that says about the viability of the institution.

Another company I see as immeasurably valuable is Epic Systems, the private healthcare informatics company, which brought in roughly $2.5 billion in revenue in 2016. Its software holds the medical records for around 64% of patients in the United States. Based on these metrics alone, Epic Systems would and I believe should receive a very high financial valuation. That valuation does not, however, take into account that the company was started in 1979 by one woman, Judith Faulkner, in her basement.

Faulkner is still with the company as acting CEO, and Epic, with a workforce of more than 9,000 people, is employee-owned. The company was founded in Wisconsin and remains there, having recently expanded its already massive campus outside Madison. Forty percent of its operating expenses are reinvested into R&D and all its software has been built in-house, with no acquisitions. Epic Systems has a 40-year story marked by loyal leadership and incentivized employees, by a founder who broke the glass ceiling and continues to innovate for the betterment of her customers and workforce.  

Beyond financial valuation

Financial valuation, far from being a solid, objective, measurable attribute, turns out to be driven by transient fashion. Everything from major policy changes to technological advancements to public oil spills can disrupt a financial valuation. What's more, behind every over-valued or under-valued company is a wealth of misinformation – narratives told by outsiders with vested interests in that business' success or failure. Businesses should look for what they can say with confidence about their company's internal system, instead. 

A well-run company identifies and connects with customers who are loyal to its product or service offerings. It becomes an asset to its community and region, creating a geographical identity. There is more to a business than the cash in its coffers or how many buildings it has or what patents and copyrights it owns. The sooner this is recognized the sooner great companies – those that grow customers and partners and encourage employees – can rise to the top of the stack and silly, bloated financial valuations become a thing of the past.