Establishing the value of a company or other investment prospect, and particularly its future value, is increasingly difficult to do, and a new framework is called for, says Helena Morrissey, chief executive at Newton Investment Management and chair of The Investment Association.
“As the financial crisis rather dramatically demonstrated, financial models based on regression analysis of the past have significant limitations when it comes to predicting the future,” Morrissey told guests at the CIMA President’s Dinner in London this month.
While the sharing economy and the internet of things have disrupted well-established business models in the past five years, the effects of climate change could see energy and mining companies left with stranded assets in the near future.
“Known fossil fuel reserves of energy and mining companies around the world total more than six times the amount of carbon that can be emitted between now and 2050 if we are to have an 80% chance of meeting the global goal of restricting temperature rises to two degrees above pre-industrial levels,” Morrissey said.
Exactly when these financial risks will take effect on the valuations of the companies affected is not clear. “Today’s companies, investors, and accountants need to fundamentally rethink orthodoxies about value creation and value capture,” she said.
A detailed set of rules cannot be future-proof – instead, a framework that recognises that change is a constant and that judgement is required in addition to conventional financial criteria is more useful. Any such framework has to allow “enough scope for radical changes from time to time in how we approach, solve, or integrate a new development,” Morrissey added.
The macro context
Morrissey outlined how Newton Investment Management assesses the value of companies in the context of these multiple transformations. Rather than relying solely on conventional financial criteria, the Newton framework seeks to facilitate dynamism, insights, and judgements.
The approach begins by looking at the broad themes likely to influence the business environment around the world. These themes help analysts identify the relevant tailwinds and headwinds, enabling them to focus their attention on a selection of companies in each sector and also play a role in the security valuation process.
One of the themes examined is population dynamics, including the implications for health care of countries with ageing populations, and growth and consumption tailwinds for those with very young populations.
Newton is currently exploring how to update its global realignment theme, which encompasses the shift in the engine of growth from developed to developing markets and now needs to be more nuanced. “We also need to capture how, in a multipolar world, power, influence, and drivers of growth are becoming more local,” Morrissey explained.
Exploring corporate culture
Getting to know a company’s management is an important factor in assessing its future value. In addition to looking at strategy, the Newton approach explores the mindset of management and the board. This includes the company’s culture, governance, and approach to its human capital, since in Newton’s view, responsibly managed companies are better placed to achieve sustainable competitive advantage and long-term growth. Culture can be a key determinant of a company’s future value, Morrissey said.
Trust also has a fundamental influence on the long-term value of a company. “It’s vital not to be daunted by the inevitably imprecise nature of assessments of culture,” she said. “It’s more honest to recognise the need for human discernment than to pretend we’ve created a model that works without it.”
One of the indicators of good governance that Newton looks for is board diversity. “Gender and other equality movements are unstoppable – and those that don’t get this are going to find they become perceived as less modern, less competitive, and less able to stay connected with their customers.”
An area for development
A significant challenge in determining the future worth of a company is how it manages and values its talent. Human capital reporting has the potential to progress traditional accounting and valuation methodologies to better reflect the knowledge-based economy, Morrissey said.
Yet at present, insight into this critical factor cannot be gleaned from financial reports, and a survey by the Chartered Institute of Management Accountants (CIMA) reveals that few companies act on, or even collect, data on this aspect of their operations.
Ninety-seven per cent of the senior decision-makers polled agree that good management and investment in employees had a direct, positive impact on the performance of a business. But 57% are either unaware of or do not use any data on their human capital when developing their business strategy.
Few companies provide information in their annual reports about the investments they make in their staff members. Twenty-two per cent of the companies represented in the poll report on staff benefits, and 23% disclose training and development costs. Employee satisfaction scores are disclosed by just 25% of the companies polled.
—Samantha White (swhite@aicpa.org) is a CGMA Magazine senior editor.