objective or subjective criteria?
Fundamental calculations? Expectations ? Market references? What else ?
There is a debate, which was heightened since the latest financial crisis,
on what type of monetary values for assets and liabilities to take into
account in corporate balance sheets.
Historical data ? Or economic fundamentals ?
Or market prices? Or average market practices ?
is a crucial, nearly metaphysical, not easy to settle, debate about
what types of values to use for assets and liabilities in corporate
This also has incidences on income statements.
debate heightened after the "subprime crisis" stroke and various
institutions (banks, insurance, funds...) went into trouble by
holding toxic assets for which they could not find counterparts in
an illiquid market.
Those assets had no more identifiable price references.
Their worths were suspected to be in many cases close to zero and
thus grossly overvalued in those institutions' accounts.
The value conundrum goes farther than balance sheet valuations.
global monetary system, well, not really a system, went wild.
It might collapse, making money itself a toxic asset.
The world lacks now a trustworthy monetary standard, a true
global monetary reference.
Reliable references to measure things are crucial, the
metric system aim was to avoid confusions. For the same reason a
reliable system to measure riches is needed also.
The approaches ...and controversies
The devilish square:
Is it possible to be at the same time
fair, right, practical, and not erratic?
Here are the main approaches
(which shows that none is fully satisfactory):
1) Full fair value (mark to market)
This phrase refers to the direct use of recent market prices ...whenever they are available.
This has become the standard vanlla method, but with some exceptions
and adaptations to tame the beast, I mean the high volatility that makes
market prices only half reliable.
There are growing controversies about the excessiveuse of those
prices in corporate statements (specifically in the financial sector) as
it leads to instability and makes comparisons ambiguous.
How to monitor the return on investments, or the overall solvency,
if the book value of assets changes all the time?
2) Adjusted fair value
This is valuing assets according to the "average" market practices.
Transient phenomena such as excessive volatility, market illiquidity
are thus averaged out.
This brings some more stability to the accounts.
On the other hand the assumptions and estimates on which those
values rest might be flawed.
3) Cost value / historic value (mark to book)
This is the acquisition price of the asset by the firm
- minus standard yearly depreciations, - and minus exceptional depreciations in some cases.
This has been the traditional method for a long time.
It could lead to large gaps between what the accounts show and the
real wealth evolutions.
4) Fundamental value (mark to model)
The fundamental value is the result of economic analyzes and projections,
which are mathematically churned into a present value (by discounting
projected cash flows).
This value takes includes indirectly not only what the physical assets of the
firm could be worth but also the estimated economic "goodwill" or
"badwill", which precisely could be related to financial prospects.
Here also there could be controversies about
* The maths used in the model, the logical assumptions and choice
of criteria. * The subjectivity of the cash flow projections.
They just translate guesses even if educated guesses, as personal or common expectations.
Who knows the future and its uncertainties?
The counter measure is to use a range of scenarios, but how to fit
multiple scenarios to accounting ? Averaging them out ? But is it
not hiding or denying the uncertainty ?
5) Market-based valuation (or relative valuation)
Relative valuation is using comparative market criteria with assets
that are seen as similar.
Price / earnings ratio and dividend yield are typical criteria, but there can
be more sophisticated ones, or even a collection of various comparison criteria.
But what is really similar to something else?
6) Potential behavioral market value
* starts by taking into account the fundamental value (see above)
* adjusts it with average market behavior criteria (in the case of
stocks, see stock image).
This method also depends of estimates that might be controversial.