Damodaran on Valuation

16.7. DEALING WITH COMPLEXITY

Reviewing the last few sections, we can now state the three basic questions that we have to address in dealing with transparency in valuation:

1. What do we use as a measure of complexity in valuation?

2. Should we reflect this complexity in value?

3. If we decide to incorporate complexity into value, how do we value complexity (or transparency)?

In prior sections, we have established that while measures of complexity exist, the ultimate test is a subjective one, and that the more complex a financial statement becomes, the more difficult it is to get basic information we need to complete a valuation. We have also shown some evidence, though none of it is conclusive, that complexity does affect value negatively. In this section, we begin by looking at why some or many analysts do not consider the complexity of firms when valuing them and why this may lead to biased valuations. We then consider ways of incorporating complexity into firm value.

16.7.1. A Case for ignoring Complexity

Conventional valuation models have generally ignored complexity on the simple premise that what we do not know about firms cannot hurt in the aggregate because it can be diversified away. In other words, we trust the managers of the firm to tell us the truth about what they earn, what they own, and what they owe. Why would they do this? If managers are long-term investors in the company, it is argued, they would not risk their long-term credibility and value for the sake of a short-term ...