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Valuation Failures

In the latest BVWire newsletter, there’s something of a bombshell (if you’re into this kind of thing):

Fair value is on hold at the FASB, observes Adam Smith (FASB), due to concerns over the BV profession. Up to now, the FASB has been a proponent of fair value in financial statements. This trend will not continue, according to Smith, because of the fragmented nature of the profession and lack of a unified set of standards. Why should the FASB spend all this time on fair value if investors have no faith in the numbers?

No faith in the numbers? That’s pretty strong language given that valuations are used all the time in business for accounting, purchase price allocation, tax and fund raising purposes.

Could it be that bad? Here’s a story I heard just last week at the IP Finance conference last week in NY. One of the panelists told the story about a portfolio of patents that his company needed to value for transfer pricing purposes. Because they were held in different countries around the world, the company decided to get two different valuations of the portfolio. One valuation came in at $100 million. The other came in at $266 million. One of the biggest differences in the two analyses was the discount rate used to calculate the net present value of the cash flows--which means that the two valuators saw very different levels of risk and opportunity in the portfolio. There appears to be qualitative analysis in the process but it’s not necessarily repeatable and verifiable.

Why is this happening? I think it’s part of the intangibles story. The shift away from a tangible, industrial economy to an intangible, knowledge economy is changing how value is created. Lots of people talk about the fact that intangibles have come to dominate corporate valuation (20% of corporate value is in tangible net worth, the remaining 80% is intangible). But there’s a lot less talk about what those intangibles are and how they should be analyzed. This leaves any financial analysis of a company open to a lot of subjectivity and variation. (By the way, the valuation community is not unique in this. Everyone is facing the challenge that the numbers don’t add up the way they used to)
What’s the answer? The first thing is to admit there’s a problem with the system. If valuations can have such a broad swing, then there’s work to do. Second, is to talk about how knowledge intangibles should be measured. How can the assumptions be handled in a more consistent way?

The answer isn’t just in the numbers. It’s hard to evaluate knowledge using dollars or quantitative indicators. What we really need is more disciplined qualitative analysis.

At Smarter-Companies we’re focusing on qualitative analysis based on stakeholder feedback. Our assumption is that those who are in the best position to judge the strength and sustainability of knowledge intangibles (like process, data, competencies, networks) are the stakeholders of the organization. They know better than anyone (including a valuator) if and how well the intangibles support the company’s value creation process.
Is there a way to incorporate stakeholder feedback in the valuation process? Yes. And I’m betting it will happen sooner than you think.

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