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Information Transparency and Valuation: Can you value what you cannot see?

Introduction

Accounting Standards

Unintended Consequences of "Increased Disclosure"

Business Mix

Reasons for Complexity

Measuring Complexity

Consequences of Complexity

Other Evidence

Dealing with Complexity

Adjust the value for complexity

Apply a Complexity Discount

Cures for Complexity

Conclusion

Information Transparency and Valuation

Business Mix

Some firms are more complex than others simply because they operate in multiple businesses, often with little in common. General Electric, for instance, has operations in more than 10 distinct businesses, with very different margins and risk profiles. Analyzing GE is therefore more difficult than analyzing a firm like Adobe Systems, a firm that produces and sells only software. Why do firms get into different and often unrelated businesses? In the 1960s and 1970s, the impetus came from the desire to diversify, which it was argued, would reduce risk.

In the 1980s, the argument was that a well-run firm could take over poorly run firms in other businesses and use its superior management to increase value. Whether these benefits actually materialize is open to question., but the complexity added to financial statements is one potential cost. It should be noted, though, that firms with complex business mixes do not necessarily have to have complex financial statements. They can provide information broken down in sufficient detail to allow investors to assess the value of the individual components. In some cases, firms can issue tracking stock on individual divisions to allow investors to get an assessment of the market value of the businesses.

Structuring of Business

When firms enter new markets or businesses, the way they structure these businesses can have an effect on the resulting complexity. For instance, a firm that keeps each business separate should be easier to value than a firm that envelops all the businesses into one entity. In some cases, firms can exacerbate problems by creating subsidiaries for each of their businesses and holding less than 100% of these subsidiaries. In the United States, for instance, a firm that owns 51% of a subsidiary will have to consolidate its statements and show minority interests as a liability.[10]

A firm that owns only 15% of a subsidiary may show only its shares of the dividends in the subsidiary and reflect none of the assets and liabilities of the subsidiary on its balance sheet. A good example of complexity created by structuring would be Coca Cola’s split-up of its bottlers in the 1980s. By making these bottlers independent entities and reducing its ownership in the bottlers below the majority threshold, Coca Cola was able to take its lowest return assets of its books and report significantly higher returns on capital. In reality, however, the partial ownership of the bottlers obscures the true returns and financial leverage of the consolidated firm.

After all, Coca Cola and its bottlers are a composite entity, with the value of one deriving from the existence of the other. The problems with cross holdings are most visible at Asian companies, especially the older conglomerates. The complicated cross holdings at these firms reflect not just the long history of these firms as private businesses (where the intent was to report as little in earnings as profits) but the current desire on the part of the incumbent managers to control these firms with minimal holdings. In some cases, the cross holdings are in other private businesses, with little or no information provides on these businesses.

Financial Choices

Three decades ago, a firm’s choices when it came to financing were straightforward. You could use common stock (equity) or bank loans/ corporate bonds (debt) and reflect the amounts raised from each on your balance sheet. As financing choices have proliferated, and new and different ways of raising funds (convertibles, warrants and other hybrids) have come into being, the balance sheet has become more complicated. An entirely new category of funding that accountants call quasi-equity, representing hybrid securities (which are part debt and part equity) now plays a prominent role in many balance sheets.

Firms have also become more inventive (with the help of investment bankers) at keeping debt off their books. Consider one example. In the early 1990s, investment bankers created a security called monthly income preferred stock (MIPs). These securities allowed firms to generate the tax benefits of debt but were treated as equity by the ratings agencies. This freed firms that otherwise would not have been able to borrow, because of bond ratings constraints, to use MIPs for expansion and investments.

While ratings agencies did catch on over time, creative bankers devised newer and more complicated instruments to let companies borrow money without having the tag “debt” attached to it. The process culminated in the collapse of Enron, a company where the accumulated debt in hidden partnerships and entities eventually came together to destroy the firm.

In Summary

Complexity in accounting statements is a reflection of both broad trends in accounting that affect all companies and conscious choices made by firms on business mixes and how they structure and present the results of their operations (accounting and financing choices).

Thus, a firm that is in a single business can end up with very complex (and difficult to understand) financial statements because it uses complex financial instruments to raise funds and is aggressive in its accounting choices. A firm with a complex business mix can work to make its financial statements transparent by going well beyond the legal requirements of disclosure.[11] By the same token, you may find the financial statements of a firm in emerging markets with weak disclosure requirements to be more transparent than the financial statements of a firm in the United States, with its stronger disclosure requirements.


10 Consolidation requires that 100% of the revenues, EBITDA and debt of the subsidiary be shown as part of the parent company’s balance sheet. The minority interest represents the portion of the subsidiary firm that does not belong to the parent company.

11 Consider the following table (based upon our very subjective analysis of the financial statements)

Prof. Aswath Damodaran

Performance Trading

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