August 2006
Intermediate to advanced
696 pages
23h 12m
English
Content preview from Damodaran on Valuation
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16.6. CONSEQUENCES OF COMPLEXITY
When financial statements are not transparent, we cannot estimate the fundamental inputs that we need to examine in order to value a firm. For instance, a firm's expected growth should be a function of how much it reinvests (reinvestment rate) and how well it reinvests (its return on capital). If firms funnel their investments through holding companies that are hidden from investors, we cannot assess either of these inputs. To evaluate a firm's cost of capital, we need to know how much debt is owed by the firm, as well as the cost of this debt. For firms that hide a significant portion of their debt, we will underestimate the default risk to which the firm is exposed, and consequently, its cost of capital.
Does this mean that the value of a complex firm is more difficult to estimate than the value of a simple firm? The answer is yes, but it does not necessarily follow that investors will discount the value of complex firms because of this uncertainty.
In fact, companies like General Electric, IBM, and Tyco prospered in the 1990s, even as they became more complex. While some would argue that the increase in value came in spite of their complexity, there are others who would present the case that it was because of it. In this section, we consider some of the empirical evidence on the relationship between firm value and complexity.
16.6.1. Cost of Opacity
In the preceding section, we referred to the opacity index developed by Price Water-house to ...
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