Is there a middle road between the two extremes? Can we value assets in complex companies while considering the potential for managers to mislead markets? In this section, we will present four practical ways in which we can adjust a discounted cash flow valuation for the complexity of financial statements. They are not necessarily mutually exclusive and represent solutions to different types of disclosure problems.
Adjust the cash flows
The simplest way to deal with complexity is to adjust the cashflows of firms for the complexity of their financial statements. In simple terms, you apply a discount to the expected cashflows, with the magnitude of the discount increasing for more complex companies. This process, called “haircutting the cashflows”, is very common both in capital budgeting and valuation, though the discounts applied tend to be both arbitrary and reflect factors other than complexity (such as risk).[18] To make this a little more objective, we would suggest the following steps:
a. Identify how much of the earnings of the firm come from assets that are invisible or not clearly identified. In particular, focus on earnings from holdings in private businesses (or special purpose entities) as well as other non-operating income (such as income from pension funds and non-recurring tansactions)
b. Assign a probability that management of the firm can be trusted with their forecasts. This is difficult to do, but it should reflect both objective and subjective factors. Among the objective factors is the history of the firm – past accounting restatements or errors will weigh against the management – and the quality of corporate governance – firms with strong and independent boards should be more likely to be telling the truth. The subjective factors come from your experiences with the management of the firm, though some managers can be likeable and persuasive, even when they are misrepresenting the facts.
In fact, the conversion of opacity into an implicit tax by Price Waterhouse represents a discounting of the cashflows. You could increase the tax rate for complex firms and estimate the cashflows for the firm with the higher tax rate. The lower expected cashflows will result in lower value. This approach is most appropriate when you are unsure about the current earnings of the firm (as stated in their financial statements) and feel that they might be overstated. An alternative approach that may be simpler is to replace the inputs for the firm with more sustainable numbers. Thus, you would change the operating margin of the firm from its reported value to the industry average and the effective tax rate to the marginal tax rate. The management of the firm will complain mightily that you are being unfair in your valuation, but the onus should be on management to provide the information that allows you to believe that they can sustain higher margins and lower tax rates.
Adjust the Discount Rate
You can also adjust the discount rate – the costs of equity and capital – that you use to discount the cash flows for complexity. In practical terms, you will increase the costs of equity and capital for firms with more complex financial statements, relative to firms with more transparent statements. There are three ways in which you can make this adjustment:
a. Estimate the historical risk premium attached to complex firms by comparing the returns you would have made on a portfolio of complex firms historically to the returns you would have earned on a market index. For instance, if you would have earned 18.3% over the last 20 years investing complex firms and only 14.1% investing in the S&P 500 index, the risk premium associated with complex firms is 4.2%. You can add this directly to the cost of equity of complex firms. The problems with this approach are two-fold. First, classifying firms into complex and simple firms is both difficult and subjective. Second, as firms change over time, you can have simple firms become complex (or vice versa), making it difficult to keep the portfolios intact.
b. Adjust the betas of complex firms for the lack of the transparency. If you trust markets, it is possible that the betas of complex firms will be higher than the betas of simple firms.[19] Unfortunately, the high standard errors in beta estimates and the changing nature of firms may make this difficult to do. Thus, the beta adjustment is likely to be arbitrary in most cases.
c. Relate the adjustment of the discount rate to the information that is not provided in the financial statements. You can estimate the beta of a firm by taking a weighted average of the betas of the businesses it is in. To do this, you need to be told what businesses a firm is in and how much value the firm derives from each business. If the financial statements are so opaque that you cannot get one or another of these two pieces of information for some of the businesses that the firm operates in, you should err on the side of caution and assume that these businesses are much riskier than the rest of the firm and attach a large enough weight to these businesses to make the overall beta increase.
d. If the complexity is not in the asset side of the balance sheet but on the liability side – significant off-balance sheet borrowing that is not footnoted or is referenced obliquely, for instance – you could adjust the debt to equity ratio to reflect the true leverage of the firm (including the off-balance sheet debt). This would result in a higher levered beta (and cost of equity) and a higher assessment of default risk (resulting in a higher cost of debt). Adjusting the discount rate to reflect complexity makes the most sense for firms where the complexity is obscuring the riskiness of the businesses that the firm is involved in and/or the financial leverage of the firm.
Adjust Expected Growth / Length of the Growth Period
In valuing any firm, two key inputs that determine value are the length of the growth period and the expected growth rate during the period. More fundamentally, it is the assumptions about excess returns on new investments made by the firm during the period that drive value. What is the relationship between complexity and these inputs? Since we derive our estimates of return on capital and excess returns from existing financial statements, you can argue that it is more difficult to
• Estimate the return on capital on existing assets for firms where both earnings and capital are obscured by accounting choices.
• Make judgments on whether this return on capital can be sustained in the future.
One way to adjust the value of complex companies then is to assume a lower return on capital on future investments and assume that these excess returns will fade much more quickly. In practical terms, the lower expected growth rate and shorter growth periods that emerge will result in a lower value for the firm.
18 Adjusting cashflows for risk can be dangerous because of the double counting that can occur when discount rates are also adjusted for risk.
19 This will occur only if the there is a link between the negative returns associated with opacity and market returns. History suggests that there should be such a link. In fact, the problems with opaque companies seem to come to the surface in down markets and not bullish ones.
Prof. Aswath Damodaran
Next: Apply a Complexity Discount
Summary: Index