Are complex firms worth less than otherwise similar simple firms? In some cases, they are and we have examined both the sources of complexity in financial statements and the appropriate responses in valuation. Complexity is the result of business decisions made by the firm (you can diversity and make your business mix more complex), structuring decisions on how the firm is organized (holding structures and consolidation) and disclosure decisions (on how to reveal information to financial markets).

Thus, firms can have complex financial statements even if they are in simple businesses because of accounting decisions they make. We developed a number of potential measures of complexity, ranging from a measure of opacity (developed by Price Waterhouse) to our complexity score (developed by asking a series of questions about companies).

If you trust managers to be unbiased in what information they reveal to markets and when they reveal this information, you could argue that complexity by itself is not a problem since the additional uncertainty created by uncertainty is essentially firm-specific and diversifiable. If, on the other hand, managers are more likely to use complexity to hide unpleasant or bad news (losses or debt), complexity will result in more negative surprises than positive ones. In this case, it is appropriate to discount value for complexity.

The discounting can occur in one of the inputs to a discounted cashflow value – cashflows, growth rates or discount rates – or can take the form of a complexity discount on conventional (unadjusted) value. It is quite clear that firms should avoid unnecessary complexity but the way to ensure this is often not new legislation or more accounting rules, since they have unintended side consequences. Instead, investors and analysts need to become more demanding of firms. If we consistently discounted the value of complex firms, we will create an incentive for simpler holding structures and more transparent financial statements.

References

Berger, Philip G., and Eli Ofek, 1995, Diversification’s effect on firm value, Journal of Financial Economics 37, 39–65.

Lang, Larry H.P., and René M. Stulz, 1994, Tobin’s q, corporate diversification, and firm performance, Journal of Political Economy 102, 1248–1280.

Wernerfelt, Birger and Cynthia A. Montgomery, 1988, Tobin’s q and the importance of focus in firm performance, American Economic Review, 78: 246–250.

Villalonga, B., 1999, Does diversification cause the diversification discount?, Working paper, University of California, Los Angeles.

Prof. Aswath Damodaran

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