Old School Value Nugget Fest

Old School Value Nugget Fest (June 18th Edition)

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Q1 hedge fund letters, conference, scoops etc, Also read Lear Capital: Financial Products You Should Avoid?

Old School Value Nugget Fest

What We're Reading in the Media

Why We Need to Update Financial Reporting for the Digital Era

Digital companies like Apple and Alphabet are huge. The article argues that financial statements fail to capture the value created by modern digital companies. So they interviewed several CFO's and asked two questions:

  1. what makes the valuation of digital companies more challenging?
  2. how can digital firms improve their financial reports to communicate sources of value creation in their businesses?

Here are the 7 distilled key points:

  1. Financial capital is assumed to be virtually unlimited, while certain types of human capital are in short supply.

Digital companies consider scientific and human resource to be the most valuable. They can always use financial capital to raise funds. Stocks and options can be used for acquisitions and employee wages.

  1. Risk is now considered a feature, not a bug.

Unlike traditional companies, digital companies love to take risk with very high rewards. For example, an employee is evaluated not based on what she contributed to the company bottomline but based on whether she identified a new, breakthrough idea.

  1. Investors are paying more attention to ideas and options than to earnings.

Companies that are run as a portfolio of ideas and projects, each with uncertain lottery-like payoffs is hard to evaluate using discounted amounts of future cash flows or earnings. CFO's of companies like this will only disclose mandatory SEC disclosures. It’s also possible that we simply don’t know how to estimate the right parameters to make an options-based valuation work.

  1. Corporate venturing is becoming more important.

Traditional companies are afraid of disruption from big digital companies. Their solution is creating a VC arm and "acquihiring" talent. This presents a cultural incompatibility within the company.

  1. Financial reporting requirements won’t change any time soon.

Current financial reporting is not sufficient any longer. One CFO commented that standard setters enjoy monopoly power and have no incentives to change their methods to be more responsive to investors. Another said that it will take a crisis to force substantive changes in the standard setting process.

  1. Analysts increasingly rely on non-GAAP metrics.

Due to difficulty in valuation, analysts make adjustments to recreate companies’ financials in their internal assessments. For example, they capitalize a part of R&D expenditures that can enhance firm’s future competitive ability and deduct a part of capital investments that merely maintain firms’ competitive ability.

  1. Sadly, accounting is no longer considered a value-added function.

CFO's feel that financial reporting is just an exercise in regulatory compliance. Audits and financial reporting are just waste of shareholder money. One CFO commented that they now avoid inviting company accountants to their strategy meetings, while another said that CPA certification is considered a disqualification for a top finance position.

Conclusion

Here's how to rethink financial reporting. Standard-setters might want to encourage disclosures related to (i) value per customer; (ii) earnings or revenue outcomes or other specific metrics related to specific projects in progress; and (iii) data on how the R&D and software talent of digital firms is being deployed.

Other Reads

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