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Enhancing Company Value By Telling A Better Tale

By Dr Richard Petty

30 April, 2007

For the average punter, ascertaining the “true” value of a company is still highly problematic. This is largely the result of information asymmetries that endure in spite of the progress that has been made in revisiting old accounting orthodoxy, and in controlling more vigorously certain types of interaction between actors in the capital markets.

The financial reporting environment has evolved to ensure that the content of publicly available company accounts is more consistently prepared and, therefore, more comparable and decision-relevant than in the past. The introduction of International Financial Reporting Standards (IFRS) and legislative changes that have sharpened and tightened mandatory reporting requirements in many parts of the world, deserve much credit for this revitalization of company reporting.  

However, if maximizing company value is the name of the game, there is still much that can be done. Most valuations still focus on market indicators, and on attaching clearer dollar signs to tangible assets. Problematically, the gamut of assumptions implicit in valuation approaches that rely upon market metrics tends to compound estimation bias. Placing faith in the end result is akin to trusting in Mystic Mary’s daily horoscope as a guidebook for life choices.

One explanation for this is that insufficient information is available to investors to adequately resolve the uncertainty that confronts them when wrestling with the old chestnut of how much risk there is and, therefore, what compensation should be sought. It is a simple progression; the blacker the box, the higher the risk premium, and the costlier the capital.

Is there a fix? Well, there is no miracle solution that will lead to the efficient wonderland that would be created by perfect information. But there are practical steps that companies can take to make their condition better known to investors, thereby inflating future value estimates and compressing discount factors in a way that delivers an immediate increase in shareholder value.

Perhaps the most effective action many companies can take is to extend their existing reporting framework to provide detailed supplementary information on the value of their intangibles. This value is in the form of both human capital and structural capital. Brands, patents, trademarks, systems, and the like being examples of structural capital.

Considerable empirical evidence now exists in support of the notion that voluntarily communicating information on intangibles, in the right way, leads to an increase in share price. The information does not necessarily have to be expressed in dollar terms. Non-financial performance metrics also work to more fully inform report users. This being the case, all interested parties are sensibly motivated to lobby for a light to be cast into the invisible corners of business that are often a hiding place for soft assets.

Flashing this searchlight with the goal of revealing underemphasised value points is exactly what an increasing number of companies, a great proportion of them located in Europe, have done. In 1994, a Swedish consulting firm, Celemi, pioneered a new approach to annual reporting by including in its annual report an ‘Intangible Assets Monitor’. Around the same time, another Nordic firm in the financial services sector, Skandia, began reporting more extensively than was required by accounting standards, or by law, on its intangibles. Both firms achieved sustained value increases as a result. Skandia and Celemi’s efforts to develop an extended reporting model are illustrative of how changes to traditional financial accounting practices can be successfully engineered by innovative managers without the need to be led by regulatory impost.

The fact that traditional financial accounting practice does not provide for the inclusion of non-financial performance indicators in organisations adversely impacts knowledge-based organisations that are looking to raise capital in the debt and/or equity markets. Intangibles such as staff competencies and customer relationships receive no formal recognition in the traditional financial reporting model. Other intangibles like brand equity, patents, and goodwill are reported in the financial statements only when they meet stringent recognition criteria.

The understanding that, for many firms, the bulk of their value is in their intangible assets, and the acknowledged invisibility of intangible value on balance sheets, has led to calls from regulators and practitioners, as well as academics, for information on intangible assets to be more fully disclosed in company annual reports.

As mentioned above, greater disclosure would be good for shareholders. The positive correlation between voluntary disclosure and increased market capitalization supports this assertion. Not reporting fully and fairly increases a company’s cost of capital which leads to lower investment and growth. Upward market pricing adjustments have been observed in cases where firms report in greater detail on specific intangibles, such as patents, and in instances where more general information human capital is given. It has also been observed that analysts reward firms that report voluntarily on their intangibles by giving more extensive coverage to them.

Extended reporting frameworks that encompass voluntary reporting have been demonstrated to return the investment made in them many times over. They also evince corporate social responsibility, and are simpatico with good corporate governance. Voluntary disclosure pays for itself in multiple ways. This leads to the conclusion that an efficient response by companies seeking an optimal market result would be increased disclosure and transparency in their reporting. So, are companies reporting optimally? If not, why not?

A recent survey of financial professionals yields some interesting insights. I surveyed 238 professionals – all of whom had significant experience in the financial services industry - to find out whether sophisticated users of publicly available financial reports found them useful, and to identify ways in which to improve financial reporting. The survey was carried out in Hong Kong, but there is every reason to expect that the results have external validity to other markets.

Unsurprisingly perhaps, more than half the respondents indicated that they do not find the accounting information provided by companies to be generally decision-useful. Nearly all respondents (96%) feel that listed companies need to disclose more information and be more transparent, and a majority of respondents (92%) do not think that companies are required to disclose enough information in their annual report. Most respondents were in favour of the accounting profession and/or the regulatory authorities imposing additional disclsoure requirements on listed companies.

The thinking of the survey participants matches the empirical data with 88% of respondents believing that voluntary disclosure of intangible assets information by companies should be rewarded by the capital market in the form of a higher share price. An even greater number of respondents (91%) think that having access to reports on intangible value will assist them in making investment decisions.

Curiously in the light of these results, a review of the external financial reports prepared by the top 100 listed companies in Hong Kong at the time of the survey revealed that no company was using an extended reporting framework to reveal the hidden value of its intangibles. So, why is it that financial professionals believe that reporting on intangibles would be decision-useful, and yet don’t do it?

There are several possible reasons. First, habits of old are hard to break. Most agents with a role in preparing documents and financial reports to be communicated to the general public seem to believe that revealing more information than is mandatory is anti-competitve. This Foucauldian stance is usually flawed in relation to company value, but it permeates the thinking of many in power. Consequently, convincing others that an entity should voluntarily disclose information may be difficult, though it should be simpler to do when armed with evidence that such disclosures positivley impact stock price. Sometimes I am asked by senior executives, ”can you tell me by how much (my company’s) market capitalisation will increase if the company reports in the way you are suggesting?”.  I truthfully answer ”no”. Understanding that voluntary disclsoure is likely to increase share price is a beginning. Fashioning a predictive algorithm to explain and quantify the likely impact of such disclsoure is a next step. Progress on developing that model has been made, and identifying directional trends is possible, but further refinement is needed. Perhaps once a fully articulated predictive model is in hand, a greater number of executives will commit to preparing extended reports.  

Second, it may be that poor awareness of how to extend existing reporting models is working against their evolution. There is evidence that points to this – most of the professionals surveyed were not familiar with the tools used by Celemi and Skandia. Only 19% of respondents claimed to be familiar with the Intangible Asset Monitor and 12% with Skandia’s Navigator.

Third, perhaps most market participants are able to fill the information void in the public domain through private channels. A majority of repsondents (60%) felt they were in a poor or very poor position to get hold of information related to the value of intangible assets of listed companies through public sources. If, however, private information channels are used, a majority of respondents (68%) reported that they could obtain good or very good information related to the value of intangible assets of listed companies. This finding is significant because it suggests that one group of stakeholders is able to gain an upper hand over other stakeholder groups because of the advantage created by special relationships. An equitable balance could be restored if companies were to report publicly the information that it seems they may be communicating privately to certain elite stakeholder groups.

The effect that voluntary disclosure has on share price works fully only if disclosures are publicly made. Enlightening all actors in the financial markets, but particularly shareholders, by making sure they know that voluntary disclosure of intangible asset information has the potential to positively impact stock prices might lead to an increase in public disclosure. Once leading firms across different industry sectors take up this challenge and the benefits of reporting in a more transparent fashion - on all pockets of value within a firm - are made clearer to all, it seems likely that other firms will mimic their behaviour and follow the leader(s). Under that scenario, all stakeholders win.