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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

Introduction

It is clear that some firms are more forthcoming about their financial affairs than other firms, and that the financial statements of a few firms are designed to obscure rather than reveal information. While differences in accounting standards across countries was viewed as the primary culprit for this lack of transparency until recent years, the convergence in accounting standards globally has made it clear that no matter how strict accounting standards are, firms will continue to use their discretionary power to spin and manipulate the numbers that they convey to financial markets.

The questions we face in valuation are significant ones. How do we reflect the transparency (or the opacity) of a firm’s financial statements in its value? Should we reward firms that have simpler and more open financial statements and punish firms that have complex and difficult-to-understand financial statements? If so, which input in valuation should be the one that we adjust?

This paper begins by examining the phenomenon of opacity in financial statements and why some firms choose to be opaque. It follows up by considering some of the empirical evidence on whether markets discount the value of complex firms to reflect the difficult faced in valuing them. It closes by evaluating some of the ways in which we can adjust discounted cash flow valuation models for this difficulty.

Consider the following experiment. You are analyzing two firms with the same market capitalization, the same overall market risk exposure and the same financial leverage. Assume that both firms have the same operating earnings, similar returns on capital and that you expect the same growth rate in the operating income. Finally, assume that firm A is a firm in a single business with open and easy-to-understand financial statements whereas firm B is a firm in multiple businesses with complex and difficult-to-decipher financial statements. In conventional discounted cash flow valuation, we would attach the same value to both firms.[1]

Most investors, however, would value firm A more highly than firm B, thus discounting the latter firm’s value for both its complexity and its opaque financial statements. Are they being irrational or are we missing an important aspect of value in discounted cash flow models? We do not think investors are irrational, and we will present an argument that we should consider these issues in valuation. We will begin by looking at the sources of and reasons for complexity in financial statements, and then look at ways in which we can adapt valuation models


1 Since the firms have similar risk exposure and financial leverage, they should have the same cost of capital. Since their return on capital is equal, they would also have the same reinvestment rates and free cashflows to the firm. The lack of transparency would be considered diversifiable risk and would not affect the cost of capital.

Prof. Aswath Damodaran

Performance Trading

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