Valuation methods and public markets debacle: Are there lessons for private company valuations?

While examining a number of valuation models and arguments by audit personnel, we found that many were overly focused on the use of sophisticated valuation tools rather than on the validity of the underlying data. The idiom "Garbage In, Garbage Out" holds true here. Like we witnessed in the Collateralized Debt Obligations (CDO) debacle on Wall Street, sophisticated valuation models with the wrong data in them or inadequate stress testing are bound to fail. Random scenario based modeling are cost effective and human judgment based discrete scenario methods are more expensive. But, should we rely on the cost-effective, random scenario calculators and ignore the human judgment-based discrete scenario computations? Rather not! The economic debacle has clearly spoken against using black box type methods.
Valuation methods and theories exist that completely define how to value companies and even privately held companies. There is really no need to keep devising newer valuation techniques or building in sophisticated volatility or stochastic models. The focus should be rather on what kinds of data go in them. Are the cash flows reliable? Are the timing of the cash flows appropriate? Are the margin calculations reasonable? Are the 3 or 5 year compounded growth rates of revenues and earnings reasonable. Is the revenue per employee or operating expense per employee reasonable for a company of a particular size, industry structure, competitive environment and financing options? Is the free cash flow to sales ratio broadly in line with industry peers? At Accuserve, we built factor models that adequately capture inputs from both qualitative and quantitative data sources, to assess the risk profile of a privately held company. This profile is then translated into a quantitative discount rate using proprietary models. Our contention is that using straight-up, vanilla Capital Asset Pricing Model or the Ibbotson Model to measure private company discount rates ar fraught with risks, and one that should not be encouraged by audit firms and especially companies that get their done overseas, who invariably employ such short cuts, to save costs and time, and are not true to the American philosophy of investigative conclusions of opinions. But should we let such philosophies creep into our mindsets here? While the private valuations are smaller and perhaps do not have the domino effect that a failed public venture may have ("too big to fail" may not apply to private companies), it is important to learn lessons from the public markets valuation debacle and apply them to private-held companies' valuations as well. That would mean we do NOT need stochastic, black box type options based models that can value thousands of companies within 1 minute, but models that force the exercise of human judgment and force the explanation of the specific economic, industry, company and customer situations that stock holders in private companies face. Valuation models should focus on verification of underlying data and applications for tests of reasonableness, more than the tools themselves. In other words, evidentiary standards on the lines of a judicial inquiry are perhaps more appropriate.
The mistakes that public companies did by outsourcing research overseas and resorting to black box models that led to failures of companies such as Long Term Capital Management (LTCM), on whose Board sat Nobel prize winning economists, says a lot about the lack of exercising subjective judgments. This country cannot afford efficiencies that come with super efficient valuation models that are totally driven by computer models and offshore analysts.
Valuation exercises that make the appraiser, the company's management and employees introspect about the nature of the businesses they are in, the future prospects, whether deployment of capital will yield more than a risk free rate creating more wealth for shareholders, is a proper mix of debt and equity used to achieve the optimal cost of capital, and whether their financial performance is in line or superior to their peers or industry are perhaps the most useful. Valuations that simply are done for the sake of regulations or done such that the cost of doing it is the lowest, with accuracy and relevancy thrown to the winds, have no meaning and should be avoided. This country cannot afford wasteful economic activities anymore, and valuation is certainly an economic activity we can ill-afford to become meaningless.
Finally, IRC 409A valuations impose a set of valuation standards, if adhered to, will surely help companies introspect and gain insights into the beneficial factors I detailed at the beginning of this paragraph. These valuations need to be used as a strategic management exercise. By treating these valuations as something purely regulatory and farming them to the lowest cost destinations perhaps makes these valuation meaningless, a cost that the country can ill-afford.

California digitizing textbooks?

In what maybe a decent move to usher in some semblance of fiscal management of the California Budget with its gaping hole, as wide as the recently discovered Borealis Basin on Mars, Gov. Schwarzenegger is talking about introducing digitized textbooks in schools - K1-K12. By some estimates, California Government's share of the textbooks comes to around $300 million (smaller than the cost of building a B2 bomber) but large enough to warrant discussions to reduce it. It is pertinent to note that digitized textbooks have already been introduced in some schools in China and other parts of the world. One of my clients is a leading promotor of digital education services in China and the company was able to profit rapidly from the Chinese government's deregulation of the Chinese education industry. Tons of paper is saved as well, which will net the California Government a large amount of carbon credits that can be further off loaded and traded in the green exchanges. Finally, information can be updated on the fly so that students do know that the Borealis Basin in the Northern Martian Hemisphere has replaced the Hellas Basin in the Southern Martian Hemisphere as the largest impact crater in the worlds we know of or that Pluto is no longer a planet in our solar system. Wait! How would the creationists react to the digitized era? That's a question best left to anyone's imagination.

The Idea Game

Welcome to Shiva Badruswamy's Idea Blog. I have created this blog to write about trends I and my partners evaluate in the innovative technology, health care and energy-related industries. We have reviewed and valued hundreds of business plans in these industries. This gives us the ability to condense idea generation trends into broad market movements that may trigger venture capital fund flows into these ideas in the immediate future. While some of our views maybe speculative, most of them are based on a solid understanding of what the market participants are evaluating when it comes to next generation of technologies.

Disclaimer: Our information is designed to help readers understand what and how innovative ideas are generated. Our information should not be used in any form or manner as prospectus material to solicit offers for investment capital, buy or sell securities, or as an analyst's guidance in evaluating performance of public and private companies. Our permission is needed for reuse of our material. Please contact us at info@accuserveus.com for more details.