Capitalism’s Valuation Challenges
Arguably, capitalism is in crisis. Part of its failings can be traced to the inadequacy of financial valuation as a measure of the true value or net worth of a company.
The prevailing capitalist model today is to maximize short term earnings, often through cost cutting, to enhance near-term financial valuations. Such a philosophy jeopardizes the longer-term effectiveness of financial intermediation and business enterprise and its contribution to sustainable enterprise and profits.
To ensure its survival, modern capitalism needs to be rebalanced towards a focus on the sustainable growth in earnings and the means to maximize corporate value. Solving the problem of incomplete and inadequate valuations will boost capitalism’s immune system of accurate pricing, risk management and valuation transparency and is a critical step in this needed rebalancing.
What is needed is a method of valuation that looks through and beyond ‘managed’ short-term accounting earnings outcomes and assesses the sustainability of longer term earnings and value creation across stakeholder relationships.
Valuation and Financial Institutions
Valuations are fundamental to the soundness of financial intermediation. Realistic and sustainable valuations minimize price volatility and forestall asset bubbles. When a bubble is growing but before it “pops”, a gradual readjustment of valuations can smooth the market’s return to a more stable price equilibrium.
Good valuations encourage investment and create incentives for longer-term holding of assets, reducing speculative dynamics.
The Basel process recognizes the link between valuations, risk, and capital requirements for banks. There is lower risk of loss and so less need for more Tier One capital when valuations are sound and sustainable.
The risk appetite of a financial firm colors its culture. In fact, it is often the case that firm culture rather drives the level of risk appetite. Bad cultures attract higher and unsustainable risk appetites as the sub-prime mortgage crisis, the London “Whale”, and more recently, Wells Fargo have demonstrated.
An enhanced method of making valuations would offset bad cultural tendencies in financial institutions. The valuations properly placed on proposed purchases and sales of assets would not support rosy projections of future profit which lure risk-seeking traders and financial advisors into dangerous waters. Valuations as the core of pricing provide checks and balances against “irrational exuberance” on the one hand and excessive caution on the other.
The Inadequacies of Financial Valuation
Financial valuation, or accounting valuation, of assets and business opportunities has become the principal pricing mechanism driving the modern free-market enterprise system. And accounting net income, where it does not overly diverge from underlying cash flows, has become capitalism’s primary measure of success.
Most of today’s current market pricing is driven by narrow financial valuations. Such valuations shape investment decisions for securities; guide investment decisions for innovation and start-ups; drive mergers and acquisitions, and management decisions on keeping, changing, or even dropping business practices; and often drive CEO compensation and bonus-incentives.
But the financial valuation of assets and business enterprise is only as good as the assumptions that underpin them. Such assumptions typically are limited to assessments of past performance and short term financial drivers and are often heavily ‘influenced’ by the interests of the beneficiaries of the valuations and the links to incentive systems.
The mispricing of mortgage backed securities (CDOs, synthetic CDOs, CDS contracts, etc.) leading to the US sub-prime crisis, for example, can be traced to incorrect calculations of future income attached to the contract rights purchased. Most of the resulting initial valuations supporting the market pricing were simply wrong. Rating agencies, conflicted by the income they received from the issuers of the securities, also relied on these incorrect calculations of future income and failed to include relevant risks and other factors in their ratings.
The fixation of corporate valuations on short term accounting results has also been driven by the linking of executive compensation to either stock prices or to the latest accounting profit result. No surprise that short term earnings management is a live temptation for corporate executives.
The scandals of Enron, WorldCom and others demonstrate that when valuations are so firmly linked to short term results, executives can be ‘incentivized’ to use accounting devices to deceive markets about the true “value” of their companies.
Beyond the above, today’s financial valuation methodology largely systemically ignores the importance of intangible forms of capital — social capital, human capital, reputational capital and natural capital. Company accounting balance sheets simply do not carry asset values for these forms of capital. This distorts our understanding of a company’s real assets and liabilities and hence value.
As the global economy has grown more scientifically advanced, with growth in knowledge workers, access to computers, and the spread of digital technologies, what counts for assets and capital has also become multiform. As a result, maintaining conventional accounting rules and practices for balance sheets built only on the concept of hard assets, important in the decades of industrial capitalism, is no longer adequate.
For today’s post-industrial capitalism — where brand, stakeholders, corporate culture, strategy, intellectual property, environmental footprints and prospects for innovation are more important sources of value — balance sheet and valuations calculations need to incorporate both tangible and intangible assets and liabilities.
Excluding the assessment of the risks and returns from intangible assets and liabilities from valuation analysis, simply results in the misstatement of value. In many ways, financial valuation, as a result, has become very detached from the “real” economy which provides jobs and goods and services growth, and promotes systemic social flourishing and respect for planetary environmental realities.
Consequently, today’s financial valuation methodology distorts capitalism towards short term profit seeking and rent extraction. It causes companies to short-change not only long-term shareholders but other stakeholders, including employers, communities and the environment.
Including intangible assets in company valuations will realign capitalism towards sustainable value creation and positively refocus incentives for investors, speculators, owners, managers, analysts, and regulators.
