portfolio of complex firms historically to the returns we
wouldhave earnedona market index.Forinstance, if we
would have earned 18.3 percent over the prior 20 years
investingincomplexfirmsandonly14.1percentinvestingin
the S&P 500 index, the risk premium associated with
complexfirmsis4.2percent.Wecanaddthisdirectlytothe
cost of equity of complex firms. The problems with this
approachare twofold.First, classifyingfirms intocomplex
andsimplefirmsisbothdifficultandsubjective.Second,as
firms changeovertime, wecanhavesimplefirmsbecome
complex (or vice versa), making it difficult to keep the
portfolios intact.
- Adjust the betas of complex firms for the lack of the
transparency.Ifwetrustmarkets,itispossiblethatthebetas
of complex firms willbe higherthan the betas of simple
firms.
32 Going back to the bottom-up beta approach that we
developedinChapter2,thiswouldaddanadditionalstepto
theestimationprocess.Afterweestimatethebottom-upbeta
forafirm,basedonthebusinessorbusinessesitisin, we
would attach a complexity premium or a transparency
discounttothebeta,dependingonwhetherthefirmweare
analyzingismorecomplexortransparentthantheotherfirms
in the sector.
3.Relatetheadjustmentofthediscountratetoacomplexity
score.Intheearliersection,wepresentedtheS&Pdisclosure
scoreandanalternativecomplexityscorebasedonvaluation
inputs.Itmaybefeasibletotiethediscountrateadjustmentto
thecomplexityscore.Forinstance,theS&Pstudyconcluded
thatthemostcomplexfirmsintheS&P 500 (top 20 percent)