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


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


Information Transparency and Valuation

Cures for Complexity

To preserve the integrity of financial markets, we must push to make the financial statements of firms both truthful and transparent. In this section, we will consider some of the ways in which we can push to make this a reality.


In the aftermath of accounting scandals in the United States, legislation has inevitably followed. After the great depression and evidence of financial skullduggery, the Glass-Steagall Act was passed, restricting banks from investment activity, and the Securities Exchange Commission was created to regulate the trading of securities. In the aftermath of the collapse of the savings and loans in the 1980s, we saw increased regulation of financial service firms in general. It is likely that the latest crisis in accounting, precipitated by the implosion of Enron, will result in new laws designed to prevent a recurrence.

While the motivation for legislation is usually noble, new laws are blunt instruments that often create new problems while solving old ones. Restrictions on the granting of options to employees may prevent pension plans from being over-invested in a company’s stock but they also undercut attempts to make managers have a stake in the company’s success in financial markets. Restrictions on special purpose entities may take away legitimate avenues for firms to reduce their cost of borrowing.

Auditing and Accounting Integrity

Accounting standards and rules are usually rewritten in response to corporate failures. No matter how strict accounting standards may be, however, accounting statements will be reflections of a firm’s true standing only if accounting principles are strictly adhered to and auditors monitor this adherence. There are three things that we can do to do to make this happen:

a. Conflicts of interest created when auditors receive income for other services provided to the firm (consulting, for instance) undercut their objectivity. Consequently, auditing firms should either spin off or divest their consulting arms. If they choose not to do so, firms should not use the same accounting firm for both auditing and consulting services.[20]

b. Accounting rules should be streamlined and discretionary choices should be reduced. In other words, we should have fewer and clearer rules, resulting in less voluminous but more informative financial filings. While this may seem to reduce disclosure, it will increase relevant disclosure and eliminate the fog created by the disclosure of minor facts. To illustrate, consider the treatment of acquisitions and management options. Instead of allowing a whole spectrum of approaches for dealing with acquisitions, all acquisitions (whether stock or cash funded) should be treated the same way and consolidated in financial statements.[21] Management options should be valued and treated as operating expenses in the year in which they are granted and not treated as expenses in the year in which they are exercised.

c. Firms should not be allowed to maintain different books for tax and reporting purposes. The different rules followed in the two sets of books for depreciation, inventory valuation and expensing adds to the complexity of the statements and make it more difficult to value firms.

d. Firms in multiple businesses should be required to report the reinvestment - – capital expenditures, depreciation and working capital - they made in each business each year, in addition to what is already reported (revenues and operating income). Some firms already do this voluntarily but all firms should provide this information.

e. Firms with capital arms – GE and the automobile companies come to mind – should be required to have a separate financial statement for these divisions. The intermingling of what is essentially a financial service firm (GE Capital, Ford Capital) with a conventional manufacturing or service firm makes it very difficult to value these firms.[22]

Skeptical Analysts and proactive investors

Equity research analysts have always been cautious about downgrading firms that they follow[23] and they have become far too accepting of management claims and promises in the last decade. The rising stock market during the 1990s explains part of the reticence to ask questions but the other reason is the overlap between investment banking and equity research.

Analysts have had to worry more and more about the consequences of downgrades and sell recommendations on investment banking revenues, and thus have become cheerleaders for firms rather than questioning analysts. It is the responsibility of analysts to demand information that they feel is critical in assessing the value of the firms they follow. For instance, analysts following a firm with substantial cross holdings are right to demand enough information about these cross holdings to value them. If the information is not forthcoming, they have to be willing to highlight this failure and use it as a justification for downgrading the firm.

Clearly, if enough analysts demanded the information, the firm would find a way to provide it or risk serious punishment in the market. As investors, it is easy to blame loose laws, incompetent auditors and snoozing analysts for complex companies that turn into investment disasters.

However, we should recognize that we bear a substantial responsibility for our failures, since we do not have to buy stocks that analysts recommend. If, as investors, we refused to buy stock in companies with complex financial statements (hence discounting value for complexity), we are providing the ultimate incentive for firms to eliminate or at least reduce complexity.

Stronger Corporate Governance

The key lesson of the Enron debacle should be that a strong and independent board is the best defense against firms manipulating earnings and hiding relevant facts from the market. It should force institutional investors who have been on the sidelines of this debate to be much more activist and push for changes in corporate governance.

In particular, they should push for smaller boards with more outside directors, selected not by the CEO but by an independent group representing stockholders. The number of directorships that an individual can hold should be restricted and directors should have no other business relationship to the firm. The issue of executive compensation has to be examined in conjunction with corporate governance.

We continue to believe that providing managers with equity stakes in the firms they manage plays an important role in reducing the conflicts between managers and stockholders, but the granting of executive options to accomplish this has created significant side costs, two of which are listed below.

• The failure to consider the value of the options granted each year as an employee expense that year, which we noted earlier, has also lead to option grants whose value vastly exceeds what executives deserve to earn, given their performance.

• While options represent an equity position in the firm, their value is driven by factors that are different from those that determine common stock. In some cases, actions that reduce the value of common stock can increase the value of options. Consider two examples. Investing in riskier businesses can make executive options more valuable, while making common stock less valuable. Though we could make a strong argument that stock buybacks are preferable to dividends for some firms, there can be no denying the fact that some firms are motivated to replace dividends with buybacks because their top managers have option positions that may be adversely affected by the payment of dividends.[24]

We would recommend three changes. First, option grants should be valued at the time of the grant and calibrated to management performance. Second, boards should consider requiring top managers to buy stock in the firm rather than grant them options. Third, boards have to monitor both investment and dividend policy to ensure that they do not get hijacked by self serving managers with large option positions.

20 It is a little unfair to pick on accountants alone in this regard. Investment bankers who design the special purpose entities for firms have their own conflicts of interest that skew the advice they offer to corporations.

21 Recent developments offer both promise and peril when it comes to acquisitions. It is good news (for analysts) that the pooling will no longer be allowed. It is not good news, however, that accountants will be called upon to make judgments on whether goodwill is impaired or not.

22 As a very simple example of the confusion created by the mixing of capital and manufacturing divisions, the debt reported by these companies is often large (reflecting the debt of the capital arm).

23 Note that this is a far weaker test than issuing sell recommendations. Analysts are reluctant to lower firms from a strong buy to a weak buy.

24 A dividend payment reduces the stock price. An equivalent stock buyback reduces the number of shares outstanding and increases the stock price.

Prof. Aswath Damodaran

Performance Trading

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