Reviewing the last few sections, we can now state the three basic questions that we have to address in dealing with transparency in valuation:
a. What do we use as a measure of complexity in valuation?
b. Should we reflect this complexity in value?
c. If we decide to do so, how do we value complexity (or transparency)?
In prior sections, we have established that while measures of complexity exist, the ultimate test is a subjective one, and that the more complex a financial statement becomes, the more difficult it is to get basic information you need to complete a valuation. We have also shown some evidence, though none of it is conclusive, that complexity does affect value negatively.
In this section, we consider three possible responses to complexity when valuing a company. The first two represent the extreme views. One is to ignore assets that you cannot see through the fog of financial statements entirely. The other is to ignore complexity entirely in valuation and trust management to tell the truth about their performance and future prospect. The last approach tries to take a middle ground, where invisible assets are valued, though the value may be discounted.
Don’t value what you cannot see
The most conservative approach to dealing with complexity is to demand information about all assets owned by a firm and all of its outstanding debt. When the information is not forthcoming or is incomplete, you view the assets as worthless. To a risk- averse investor, this may seem not only sensible but prudent. If all investors adopted this approach, firms with valuable assets would, it is argued, be forced to be forthcoming.
There is some merit to this argument but it has a potential downside. If most firms have complex financial statements and other investors are less demanding than you are, you many very well end up as a bystander in the equity market. If that is not a viable option – you may be the manager of an equity mutual fund who is required to be fully invested in equities at all times – you may have to bend on these rules.
The problems become even worse if you have to invest in younger or higher growth companies, where the reason for the complexity may be the business itself and not intransigent management. Even if a Cisco or a Biogen were absolutely forthcoming about their research and development expenses and acquisitions, you may still find yourself short of the information that you need to correctly assess their value.
Trust the firm to reveal the truth
At the other extreme, you can trust the managers of the firm with invisible assets to tell you the truth about these assets. Why would they do this? If managers are long-term investors in the company, it is argued, they would not risk their long term credibility and value for the sake of a short term price gain (obtained by providing misleading information). While there might be information that is not available to investors about these invisible assets, the risk should be diversifiable and thus should not have an effect on value.[16]
This view of the world is not irrational but it does run into two fundamental problems. First, managers can take substantial short term profits by manipulating the numbers (and then exercising options and selling their stock) which may well overwhelm whatever concerns they have about long term value and credibility. Second, even managers who are concerned about long term value may delude themselves into believing their own forecasts, optimistic though they might be. It is not surprising, therefore, that firms become sloppy during periods of sustained economic growth. Secure in the notion that there will never be another recession (at least not in the near future), they adopt aggressive accounting practices that overstate earnings. Investors, lulled by the rewards that they generate by investing in stocks during these periods, accept these practices with few questions.
The downside of trusting managers is obvious. If managers are not trustworthy and firms manipulate earnings, investors who buy stock in complex companies are more likely to be confronted with negative surprises than positive ones.
This is because managers who hide information deliberately from investors are more likely to hide bad news than good news. While these negative surprises can occur at any time, they are more likely to occur when overall economic growth slows (a recession!) and are often precipitated by a shock. In early 2002, the fall of Enron and the exposé of its accounting practices had a domino effect on the stock prices of Tyco, Williams Energy and even GE, all viewed as complex companies.[17]
16 This follows from the assumption that managers are being honest. If this is the case, the information that is not available to investors has an equal chance of being good news and bad news. Thus, for every complex company that uncovers information that reduces its value, there should be another complex company where the information that comes out will increase value. In a diversified portfolio, these effects should average out to zero.
17 The concerns about accounting practices were global. Post-Enron, European firms with opaque financial statements such as Siemens found themselves confronted with demands for more openness from their stockholders as did Asian companies like Samsung.
Prof. Aswath Damodaran
Next: Adjust the value for complexity
Summary: Index