If you run a company, why is the delivery of reliable and timely information to stakeholders so important? The answer is simple: because information, more than anything else, influences company valuation. Let me explain how it all works.
The risk of information asymmetry
Information asymmetry can be defined as a situation in which one party has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer. In some cases, the reverse can also be true.
For example, I know more about my driving habits than my insurance company. Borrowers know more about their financial prospects than lenders. Company insiders know more about the future of the firm than shareholders. Often there is a great temptation to exploit this advantage, to capitalize on information asymmetry.
The lemons problem
Companies are obliged to provide reliable and timely information to the market. But what would happen if a company were to break the agreement on reliable information disclosure? How would market price the company in this case?
The classic lemons problem starts with a well-known setting. Imagine that half of the products are “good” and the other half are “bad”, but a buyer doesn’t know, which is which. From the point of view of the company, this scenario is only attractive to the owners of “bad” products.
Namely, if the original distribution of earnings is (0;100), the existence of lemons would force a risk neutral investor to pay 50 for the equity. In this case, companies at the higher end of distribution (50:100) would not be willing to take the offer, and this in turn would lower the investor’s proposed average price further to 25. In theory, this development would eventually lead to a risk-neutral investor not being willing to pay anything for the worst possible company. In other words, no investments would be made.
This scenario shows a process of a total market breakdown.
Value = company assets + intellectual capital
The lemons problem is an extreme example of extreme information asymmetry. In reality the situation is usually not that bad, but the same mechanism still applies.
For financial markets, a company’s financial report represents the most significant source of information. It is the number one tool when pricing decisions are made. While there are plenty of nuances, legislation ensures the reliability and reader friendliness of this information for the most part.
However, a listed company issues financial statements only four times a year, while significant decisions that can affect a company’s future cash flows are made continuously. This is why a company’s information announcements have a crucial role.
But that’s not all. Usually the market value of a profitable company is significantly higher than the book value of equity (i.e. the difference between assets and liabilities on the balance sheet). This is because an enterprise value – the total value of a company – consists not only of the value of the company’s assets but also something that can be called: intellectual capital.
This form of value is not easily observable and cannot be found on the company’s balance sheet. It includes all the know-how, customer relationships and brand value that is expected to generate future profits over and above those that correspond to the book value of the fixed and current assets on the balance sheet.
The picture below describes the situation.
Systematic management of information as the source of trust and credibility
So, how can a company communicate this very significant part of its value that is not seen on the balance sheet to the investors on the market – in practice mainly to the analysts and active investors that price its stock? How can a company resolve the information asymmetry problem, and build trust and credibility?
This goal can be achieved by systematically managing the flow of information. Efficient utilization of press releases, editorial media connections and social media channels is crucial for a company to convey this information to the markets.