Zane Swanson, an accounting professor at the University of Central Oklahoma, has been at work on a fascinating new approach to the valuation of firms and the valuation of their equity shares. This approach may be of great interest to risk arb hedge funds.
Swanson is working with an established model, the structural equation model (SEM), which looks to fit networks of constructs to the data. SEM adepts employ visualization: that is, they draw diagrams in which latent variables appear as circles, and observed variables appear as squares. Arrows among the various figures, circles and squares, indicate causation. The direction of inference is from the squares to the circles.
In the case of the valuation of a firm, SEM proponents suggest starting with a “clean surplus concept” and then dirtying it up as necessary. The clean concept takes the value of the firm to consist of beginning book value, goodwill, and net income. Then “additional information economic features” can be added to the account to reflect the complete set of realities that have an impact on firm value.
Adding Simultaneous Regression
Swanson’s contribution is combining the SEM approach with a simultaneous regression system. The simultaneous regressions begin with elements of the clean surplus. Specifically, the dependent variables of the regressions are firm market value and net income. The other item, goodwill, Swanson treats as, in his words, “the intangible value of an external acquisition in the amount that the consideration exceeds the net fair value of the acquired entity.”
Swanson presumes that net income is driven by a set of variables that include implied intangible factors. This is how he brings together the two parts of his model, the simultaneous regressions and the SEM. He assumes that internally generated asset values will have to be implied as latent variables (circles rather than squares.)
In the course of his literature review, Swanson observes that there has been a paradigm shift in accounting in recent years from historical cost valuation to fair value, which Swanson deems appropriate as a way of bringing accounting into line with the economics of the firm.
One important issue facing accountants, and financial analysts, today is the fair value of various sorts of intangible property that themselves are essentially information. Back in the 19th century, value chains were centered on manufacturing. Somebody would buy raw materials, keep them stored as inventory until the assembly line was ready for them, transform them into something new, and then sell that new value-added thing.
Then came the rise of the service economy, where the adding of value along a vertical chain is trickier to measure. Furthermore, even in the remaining manufacturing sector, that more traditional value chain includes “service attributes which sell/maintain the products.”
Conservatism and Consequences
The logic of GAAP has long been in favor of conservatism in the valuation of intangible assets.
For example, when a firm does research and development work, the work is usually expensed within the current period, rather than being capitalized.
This conservatism has consequences. Suppose a firm that has done promising R&D within its field is acquired. The R&D value at this time will be identified and paid for. Swanson says that obviously “this purchased R&D value did not suddenly appear out of nowhere.” Getting firm valuation right, improving the assessment that present accounting practices generate, is then possible if someone (such as a potential acquirer) is on top of such issues as the firm’s internally generated intangible values.
Indeed, Swanson cited an economist at the Federal Reserve Bank in Philadelphia who estimates that US companies have more than $8 trillion in intangible assets.
The world of risk arbs certainly would want to improve its understanding of where those $8 trillion are to be found exactly, and Swanson’s model may be one way forward to that goal.