Having spent over 22 years with EY (formerly Ernst & Young), advising on acquisitions, flotations, privatisations, business and share valuations and business investments in general, I have come across numerous reasons for investment, some of which were objective financial or strategic targets and some which were merely idiosyncratic whims of powerful proponents.
My team’s role was always to identify the financial and strategic benefits of an investment decision and present them rationally. Every decision carries risk and involves a hypothesis of future events and circumstances, but a lack of certainty doesn’t excuse a lack of sound appraisal.
During the past 16 years, we have seen interesting ideas around investments and related asset valuations in our own social housing sector, with some debatable appraisal and valuation methodologies still apparent, and my particular concern is with the rationalisation of financial, social and strategic values within investment appraisals and asset valuations.
Every investment has desirable attributes that cannot be monetised, as well as a monetary cost and prospective returns. It follows that any asset (resulting from past investments) has monetary and non-monetary values. Humans make sense of this in their day-to-day investment decisions, for example when buying a car, by ranking the value of the non-monetary attributes they want (such as mpg, colour, speed, fashion and comfort) and buying the vehicle that they can best afford from their attribute list. Compromises can be made around desirable attributes, but affordability is an absolute that should be adhered to (whims notwithstanding). Perpetually ignoring the absolute constraints of affordability in one’s day-to-day financial decision-making is the road to bankruptcy. A complex scoring system may, however, be a useful explanation to one’s spouse for any overspending.
Commercial investment decision-making is no different. Ignoring differing attitudes to risk, which is a whole other topic, overall investments must always adhere to financial constraints (there are always individual exceptions), whereas compromises can more often be made around some of their non-monetary objectives.
The subsequent value of the aforementioned car (or any asset), similarly, involves its non-monetary attributes as well as its financial (disposal, continued use or replacement) values. Combining monetary and non-monetary values to create a single ‘value’ can look decisive and elegant but does it have any credence?
The housing sector’s history of combining monetary and non-monetary values, or scores, may be a hangover over from tendering activities, where a tender is often afforded a score out of 100 for its price, to be combined with scores for other desirable attributes of the tender submission. It can be suggested that this flies in the face of the argument that, to be successful, all organisations should buy the best they can afford. In law, combined scoring of this nature would be a target for the prosecution challenging the efficacy of a failed procurement.
By scoring and weighting all non-monetary requirements, then ranking the scores before comparison against prices (‘to buy the best they can afford’), discretion could be retained, and subjectivity would be reduced in the overall investment decision.
The process of buying the best one can afford carries over to values. If assets are retained, disposed of or replaced without considering the absolute nature of one’s financial position and their impact on it, then any sensible investment decisions that went into building that financial position can be undermined.
In commercial corporate finance, the problem of reconciling financial and strategic values is overcome by considering them as two sets of variables that interact to inform a sound decision, with some strategic imperatives driving an investment, others merely influencing it. If they do neither, then why are they considered at all?
If a strategic or social objective can be monetised, it can be included in financial projections. Otherwise, it may be subjected to some form of ‘desirability’ ranking. Moscow rules (must have, should have, could have, would have) are useful starters. If a single non-monetary attribute score is needed, then scores can be applied to each desired attribute for an asset score. In identifying values driving or influencing an asset’s value, there are bounds to human rationality. It’s claimed that an average human can hold between five and nine variables in working memory at any one time.
If, say, 20 separate values are included in arriving at the non-monetary value of an asset, it becomes difficult for the average human to understand the relevance of a single value score for that asset or to understand the key drivers of that overall value, thereby preventing consensus-building. It also stretches the concept that the asset’s value should only be based on values that drive or influence financial investment decisions surrounding the asset.
The US economist Herbert Simon suggested that economic agents often use heuristics (rules of thumb) to make decisions rather than a strict rigid rule of optimisation, due to their inability to process and compute the expected utility of every alternative action. This remains true, hence the need to limit the degree of heuristics (i.e. artificial scoring of an otherwise sound value measure) applied to the financial elements of decisions; instead looking for sound financial measurement of intended investments and of their opportunity costs. By contrast, regardless of the clarity of non-monetary values, heuristics remain in scoring them for decision-making purposes.
As financial constraints become tighter, affordability becomes a more important element of investments and maintaining or improving the financial value of an asset portfolio becomes imperative. As our sector moves from a subsidised regime to one that is fully commercial, eking out subsidies while complying with regulatory demands complicates financial decision-making but increases its importance. Non-monetary factors cannot be ignored in investments or portfolio improvement and not all strategic drivers for investment can be monetised, just as not all factors that contribute towards an organisation’s goals can be monetised. However, the assessment of the financial aspects of investments and portfolios can use rigorous and objective bases, demonstrating sound custodianship. Once evaluated, financial conclusions can be led or challenged by non-monetary considerations.
The sector should reconsider the concept of a single value for an asset that combines financial scores with non-monetary attribute scores. Generally, such models combine the NPV of net earnings with social values but in certain circumstances, asset market value may be more important than both and even net-book values can sway because of the potential impact on published accounts or charges. Hence, even financial values cannot readily be combined; but they can at least be compared.
Armed with a non-monetary value for an asset and its various financial values (NPV of net earnings, OMV-VP, EUV-SH, NBV and so on), assets and groups of assets can be compared, and valid investment decisions made using tried and tested commercial appraisal techniques. For instance, the ubiquitous two or three-dimensional BCG Matrix or ‘Boston Box’ can be adapted to:
- Compare strategic values with earnings to identify the best and worst performers and hence imperatives for improvement, disposal, etc;
- Compare earnings values with disposal values for poor strategic performers;
- Categorise assets to identify investment-worthiness;
- Make sense of more than one competing value.
Analytics software applied to monetary and non-monetary values can suggest improvement strategies. Predictive analytics from finance and other systems can identify asset value improvement possibilities that traditional investment appraisals can’t.
A wealth of information, often outside finance systems that can sometimes lack granularity, can now be very easily harvested with modern business intelligence software to aid organisations wanting to understand asset value drivers to improve their portfolios and investment decisions.
Until valuation gimmicks and customary forecasting and valuation practices are challenged, the sector will not equip itself for the very challenging financial future in front of it.
Ian Ellis MBA is the CEO of AspireBI.