Damodaran on Valuation

Chapter 16. The Value of Transparency

When valuing firms, we draw on financial statements for information and trust these statements to provide us with reliable data on what a firm earns, what it owns, and how much it owes. Not all financial statements, though, are created equal, and some are clearly more difficult to work with (from a valuation perspective) than others for two reasons. One is accounting malpractice, where financial statements withhold relevant and material information or provide incorrect information about the firm. The blame for misleading and incomplete financial statements does not necessarily lie with the regulatory authorities, and tightening disclosure laws will not make the problem go away. The other reason is corporate complexity. Even with equally informative financial statements, some companies are easier to value than others simply because they are less complicated; Wal-Mart is a much easier company to value than General Electric.

In this chapter, we consider whether the complexity of a company should have an effect on its value. To answer this question, we begin by discussing why complexity might matter to investors and then examine two much thornier questions: What is it that makes a company complex? And how do we measure complexity? We then consider the empirical evidence on how investors deal with complexity when valuing companies. We close the chapter by looking at ways in which we can incorporate complexity into both discounted cash flow and ...