Profit and Cash; Opinions and Facts. Chapter II.

Dear friends,

After I posted my last comment, I’ve received some emails and a public comment (thanks Adavi), asking my opinion about the topic.

Of course this is a very complex topic that I’m not capable of describing in just a comment, but I’ll try to give some ideas.

In my opinion, we’re in the first steps of a systemic change towards a knowledge based economy driven by efficiency and productivity.

The Assets Bubbles we’ve seen on the last 15 years (.com, real estate, derivatives and government debt) are just one side effect of the lack of correlation between the price of the limited natural resources and their long term value.

As the valuation of assets is a critical activity on the assignment of resources to a specific initiative/investment, the systemic change on the economy will be oriented by new methods on the valuation of the assets.

I remember, months ago, I had a very exciting discussion with one of my best friends, Financial Controller and lecturer of Corporate Finance in a prestigious Business School, about the topic of Assets Valuation.

Simplifying, we accept two main valuation methods.

-          Mark to Model. Based on moving in time the expected future cash-flows by using a coefficient (interest rate) representing the risk (default, operational and market) of the investment.

-          Mark to Market. Based on the idea that all the market agents have the same information and they will exchange the assets at its “Fair Value”.

In my opinion the experience proves that both assumptions are incomplete. On one hand the Financial Markets are far from being perfect and the determination of future expected cash flows has proved to be a very difficult activity.

During the industrial revolution, long time before the first resources crisis (like the oil crisis of the 70’s) we developed methods for determining quite accurately the expected cash flows of an investment, as the scenario was stable enough (for example, the sales of General Motors in the decade of the 50s).

But the more we move towards a Knowledge Based economy, the more critical and challenging becomes developing new methods for determining the future cash-flows that an investment can generate.

For example, when in 2006 Twitter was founded I don’t think it was easy to determine the future cash flows that the initiative could generate according to a “classical” perspective. In fact when at the time "Biz" Stone was asked publically what was the company business model, he answered “I don’t know”.

If we look at a genetic engineering company, capable of generating more productive soya seeds, in a research process which can last for 10 years, non-classical components of the value like the Intellectual Capital become the main one for determining the value and risk of the investment.

From a portfolio management perspective that’s extremely challenge as it requires an integral vision that the current information systems don’t have, but we cannot afford not having.

What do you think?

Kindest Regards.

June 12th, 2010