Adjust the Cash
FlowsThesimplestwaytodealwithcomplexityistoadjust
thecashflowsoffirmsforthecomplexityoftheirfinancial
statements. In simple terms, we apply a discount to the
expected cash flows, with the magnitude of the discount
increasingformorecomplexcompanies.Thisprocess,called
“haircuttingthecashflows,”isverycommoninbothcapital
budgetingandvaluation,thoughthediscountsappliedtendto
bebotharbitraryandtoreflectfactorsotherthancomplexity
(such as risk).
31 Tomakethisalittlemoreobjective,wewouldsuggestthe
following steps:
1.Identifyhowmuchoftheearningsofthefirmcomefrom
assetsthatareinvisibleornotclearlyidentified.Inparticular,
focus on earnings from holdings in private businesses (or
special purpose entities) as well as other non-operating
income(suchasincomefrompensionfundsandnonrecurring
transactions).
2.Assignaprobabilitythatmanagementofthefirmcanbe
trusted with their forecasts. This is difficult to do, but it
shouldreflectboth objectiveand subjectivefactors.Among
the objective factors is the history of the firm—past
accounting restatements or errors will weigh against the
management—and the quality of corporate
governance—firms with strong and independent boards
shouldbemorelikelytobetellingthetruth.Thesubjective
factorscomefromourexperienceswiththemanagementof
thefirm,thoughsomemanagerscanbelikableandpersuasive
even when they are misrepresenting the facts.