A recent article in the Harvard Business Review (HBR) asked how digital companies can improve their financial reports to better represent the value of their businesses. The authors of Why We Need to Update Financial Reporting for the Digital Era identified several key insights, including the following:
Human, not financial, capital
Digital companies view their development, software and scientific personnel as their most valuable resource and the priority for the CEO is to deploy human resources to the most important projects. In this light, financial capital allocation is less of a priority, as digital companies have more scope than traditional businesses for raising financial capital.
Value of risk
Risk is a part of life for CFOs in all businesses but for those in digital companies, risk is more a way of life. In fact it's actually desirable, meaning that ideas for new business ventures and projects that seem risky but have huge profit potential are valued more highly than business projects deemed low-risk but low-return.
Justifying market cap
Rather than valuing a company based on its future cash flow and earnings, emerging companies are valued more on the potential of their ideas and projects, which often have uncertain 'lottery-like' payoffs, according to the HBR authors. They write: “CFOs of these companies themselves admit that they cannot justify their market capitalizations based on traditional metrics. They conjecture that their market values might be the sum of the option values of the projects undertaken, a sum of best-case scenario payoffs. One CFO said that her valuation should be considered on a per idea basis instead of a per earnings multiple.”
Reporting reform needed
The current financial reporting model doesn't meet the needs of modern businesses and investors but there doesn't seem to be much prospect of reform. The article's authors note: “companies increasingly resort to provision of proforma and non-GAAP reports, even though this practice is looked down upon by the SEC and is opportunistically misused by a few companies.”
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