RT an article on valuations..with no conclusions, just thoughts and groups working on the puzzle....
When it comes to investing, what you don't know can hurt you.
By Eileen Buckley
What explains the blockbuster IPO of a company with a good story but no
earnings history? Or, on the other hand, why is it that the slightest bad
news, or a less-than-perfect financial report, can send a perfectly healthy
stock plummeting?
When investors appear to disregard a company's historical financial
performance the moment a bit of unexpected news or a story surfaces, they
often are reacting to what is called "information asymmetry." The asymmetry
occurs because traditional financial reporting methods ? audited financial
statements, analysts' reports and press releases ? disclose only a fraction
of the information relevant to investors.
For instance, information about a company's intellectual capital, while
known to company insiders, is not systematically communicated to investors.
Since intellectual capital is often the most valuable asset a technology
company has, investors have no other choice but to rely on guesswork, rumor
and innuendo when judging the reasonableness of a company's value.
Intellectual capital is an unrecorded asset, which means that although it is
something of value, it is not recorded anywhere on a company's financial
statements. Copyrights, trademarks, brands, staff, and research and
development are all examples of intellectual capital.
Since its true value is contingent on a future event, it's difficult to
calculate a precise measure of intellectual capital. Accountants, who deal
with historical costs rather than future value, are perfectly justified in
ignoring it. By way of metrics, analysts do their best to indirectly capture
some of its value, but such methods tell only a small part of the story.
So is there a reasonable basis for valuing the intangible asset of
intellectual capital? And if so, why not disclose this information to
investors? These questions are being hotly debated right now within the
Securities and Exchange Commission, traditional accounting firms and
academia.
The issue is on the radar screen of Arthur Levitt, chairman of the SEC. Greg
Corso, senior counsel to the chairman, reports that Levitt has pulled
together a group of experts ? led by Jeffrey Garten, dean of the Yale
University School of Management ? to debate the matter.
"A lot of smart people are giving a lot of thought to these issues, but I
don't think there is anything resembling a consensus," says Corso.
To get an idea of the enormity of the unrecorded value, consider the
mathematical machinations involved in a merger or acquisition, which
typically forces the valuation of a company's intellectual capital. When
America Online announced that it would acquire Time Warner (TWTC) , for
instance, AOL said it would exchange $146 billion worth of stock and agree
to pay $38 billion of future liabilities for a company with net tangible
assets of $9 billion.
After the announcement, Time Warner's identifiable intangible assets and
goodwill were each valued at $95 billion.
There is a basic disconnect between accounting, which is based on historical
cost, and a company's future cash flow value," says Michael Lloyd, a partner
in the corporate value consulting group at PricewaterhouseCoopers who
identifies intangible assets paid in acquisitions. In traditional
accounting, the value of a technology exactly equals the value of the asset
contained in inventory. But, says Lloyd, there is a tenuous connection
between this inventory value and the value the technology will generate in
the future.
To derive a more accurate reflection of a company's market value,
accountants use the method of discounting future cash flows to estimate
assets such as in-process research and development. Human capital,
frequently a company's greatest asset, is calculated by estimating the cost
of recruiting and training a new workforce.
Even after applying established formulas, there is usually a huge chunk of
unidentified value left over called "goodwill." Some goodwill is just
unidentifiable value, but some is a result of tech-stock inflation.
"Companies have cheap currency to use to buy companies," says Lloyd. "If
these deals were being done on a cash basis, the values would be much
lower."
PIECES OF A PUZZLE
How, you might wonder, did the financial reporting system become so
disconnected from the real value of a company? This is a crucial question,
especially when regulatory bodies like the SEC were set up back in the 1930s
to bridge this type of information gap between companies and investors.
Decades later, when a new type of asset called intellectual capital began to
become the dominant value of companies, information asymmetry grew again.
Today, it accounts for no small part of the financial market's volatility.
So what does all this have to do with investor jumpiness? If you own a
security in a company with a $20 billion market capitalization, but with
life-to-date revenues of $10 million, you probably suspect that there is a
large gray area in the valuation picture. Maybe you turn to analysts to fill
in the missing information. But an analyst's metrics supply only a piece of
the puzzle.
So you, along with other investors, are left with an information vacuum when
trying to rationally assess the value of this security. And since investors
by nature abhor a vacuum, rumor and innuendo, PR departments and market hype
quickly rush in to fill the space.
For Baruch Lev, an accounting professor at New York University, this
information vacuum creates untold damage to investors and companies alike.
Lev spends much of his time researching and publishing his findings on this
topic, in an effort to educate people about the damage done when investors
lack accurate information.
As an example, he recalls recent events surrounding MicroStrategy (MSTR) ,
in which the company's stock fell 62 percent in one day after it restated
its revenue figures. "Almost two-thirds of the whole company was damaged in
one day, while nothing happened to the fundamentals of the company. They did
not announce that products failed, or that alliances were broken up, or that
they lost customers. It was the same company, only [with] a new accounting
method."
But what accounts for such a stunning decline? "In my opinion, investors
didn't know anything about this company before," says Lev.
To remedy the situation, Lev advocates that companies be required to supply
more information to investors. But if history tells us anything, it is that
regulators will have to force this information out of companies.
"In the 1920s, the New York Stock Exchange tried to get some information out
of listed companies," says Lev. "They wanted to get revenues, just revenues,
which seems so innocuous today. But the managers protested:'This will be the
end of the free markets, this will be the end of companies, it's proprietary
information,' they said."
What managers don't know, claims Lev, is that they are hurting themselves by
not being forthcoming with financial information, because of a principle
called the "lemon's discount."
For instance, if you try to buy a car from a used car dealer and find that
the dealer has no information about its history, a savvy car buyer might
assume that the car is a lemon and therefore only pay the value of a lemon.
The same is true for companies. The less information a company provides its
investors, the less likely it is to score a realistic valuation.
But how much of the missing picture can be filled in? On this matter,
opinions vary widely. But consensus is emerging among academics and
regulators on one thing: Both investors, who will be less exposed to the
risk of exploitation, and companies, who will be more likely to achieve
realistic valuations, will benefit from better financial reporting and
disclosure.
For Lev, the sooner this change happens, the better. "There is no magic
here. If you want to be able to assess what is missing now, you need some
information about a company's customers, about its employees, about its
capability to research and bring products quickly to market. The current
situation is that all this information to some extent is proprietary. The
current situation is that nothing is out and people feel great uneasiness."
And uneasiness breeds volatility, which in this market is the sign of either
too much information or not enough. |
