Thursday, 14 February 2013

What are You Worth?

In today's Globe and Mail newspaper, a CEO of a major insurance company (Don Guloien - Manulife) and the Dean of a Business school (Roger Martin - Rotman) unite to challenge an accounting rule.  They say that Mark-To-Market is causing unnecessary volatility in the stock markets.  Normally, I would scoff at the thought that an accounting rule could possibly have that much power, but in this case, I think they have a point.

As a profession, we are choosing asset valuations that are easy to measure over valuations that reflect the underlying economic reality of the asset.  Here's an example.

How much are you worth as an employee?  If I were to value you at your market rate, I would take the salary and benefits of a comparable person in the market place and do a discounted cash flow analysis using a current interest rate and arrive at a valuation.  That is one of the options in mark-to-market valuation.  If the interest rate changed or if there was a sudden shortage/surplus of similar people to you, your valuation would change.  This type of valuation is very sensitive to interest rates, meaning that a small change in interest rates causes a large change in the value.

But does the market value reflect your true economic value to your employer?  I would argue that it doesn't. Your employer is not holding you as an investment to be sold when the market goes up.  Your employer values your work at a higher level than your market value at the time of hire, otherwise why hire you?  At the same time, as long as you and your employer have a lasting relationship, fluctuations in your market value are irrelevant.  So it is with the assets owned by a company  Unless the assets are being held for sale, fluctuations in their market value are irrelevant.  Being conservative, if the market value of an asset falls significantly, accountants will question it, but that's not the same as chasing every fluctuation in value.

Normally, I would expect sophisticated readers of financial statements to understand and interpret changes in market value, but I see so much evidence of purely numeric modelling where financial numbers are just fed into the machine without much analysis.

We need to bring back professional judgement and put more time into understanding a company's situation rather than just making it easier to audit.