< Previousby t (40) = 3.80, P <.001. N o significant difference was found between the average MAE for the GDP-based forecasts and the average MAE for the historical industry average-based forecasts, as evidenced by t (40) = -1.15, P <.4895. T hese results suggest that relying on the inflation forecast published by the CBO will not produce the most accurate long-term growth rate forecasts. Relying on either published GDP growth forecasts or historical average industry growth rates is preferable, as they produced the lowest MAEs. Conclusion This research tested the accuracy of 10-year industry growth rate forecasts over the period 2010 to 2020 premised on inflation and GDP growth forecasts published by the CBO in January 2010 and 10-year historical average industry growth rates for 2000–2010. These forecasts were tested against actual industry growth rates from 2010 to 2020. The results revealed that, on average, industry growth rate forecasts based on the inflation forecast published by the CBO are inferior to the GDP forecast published by the CBO and historical 10-year industry average growth rates. On average, there was no statistically significant difference found between the GDP-based forecasts and the historical average growth rate forecasts. Assuming that a firm’s revenues will grow at the rate of inflation will not produce the most accurate long- term growth rate forecasts. Selecting a long-term growth rate based on published GDP forecasts or a historical average industry growth rate is the superior approach. Gene A. Trevino, PhD, CFA, ASA, is an economist with Economic Evidence in San Antonio, Texas. Dr. Trevino specializes in the valuation of closely held businesses and the calculation of economic damages and has been providing expert witness testimony in these areas for over 30 years. Email: Table 3. Mean Absolute Errors by Industry and Forecasting Method CPIGDP Historical Average Agriculture—farms0.05580.05620.0568 Oil and gas extraction0.22930.22650.2232 Utilities0.05700.05920.0639 Construction0.04750.02750.0460 Manufacturing—durable0.04280.04350.0441 Manufacturing—nondurable0.05940.06770.0619 Wholesale0.05130.04190.0391 Retail0.03140.00950.0177 Transportation—truck0.05280.04480.0461 Warehousing and storage0.04880.03560.0384 Information0.04880.03560.0378 Finance and insurance0.03000.01210.0085 Real estate, rental, and leasing0.02640.01010.0110 Professional and business services0.03690.02010.0146 Professional, scientific, and technical services0.03270.01880.0164 Management of companies and enterprises0.03630.01990.0132 Educational services0.02690.03030.0532 Healthcare and social assistance0.02910.01760.0276 Arts, entertainment, and recreation0.05840.04490.0473 Accommodation0.07200.05520.0612 Food services and drinking establishments0.05310.03270.0321 Average mean absolute error0.05360.04330.0457 20The Value Examiner Valuation PE.S_VE_JulAugAd_2021.indd 1PE.S_VE_JulAugAd_2021.indd 16/22/21 9:45 AM6/22/21 9:45 AMDigital assets are quite literally transforming commercial activity. Broadly speaking, digital assets encompass any asset that exists in the digital world in binary form and whose right-to-use can be bought, sold, or transferred. Digital assets can include images, videos, intellectual property, and software, to name a few. Crypto assets are a subset of digital assets that function as a medium of exchange. According to an Association of International Certified Professional Accountants Practice Aid (the Practice Aid),1 other defining characteristics of crypto assets are that they do not result in a contract with another party—which might include an ownership interest in another company or a contractual claim to another asset—nor are they considered a security under the Securities Acts of 1933 or 1934. Cryptocurrency, such as bitcoin and ether, is a type of crypto asset2 that has become an increasingly popular way for companies to engage with digital assets. But unlike government-issued “fiat” currencies, cryptocurrency is not issued or regulated by a jurisdictional authority. Although an increasing number of companies and institutional investors are investing in cryptocurrency, the accounting rules have not been keeping up.3 For example, Tesla revealed an aggregate investment of $1.5 billion in bitcoin in its most recent annual report. But how should this investment be reported in the financial statements? Intuitively, it makes sense to look for currency, digital or otherwise, under “cash or cash equivalents.” A position in cryptocurrency might also be considered an investment. However, a current interpretation of existing, authoritative accounting standards lands this type of crypto asset in an asset class alongside goodwill: an indefinite-life intangible asset; not amortized, but tested annually for impairment. In the absence of specific authoritative guidance for crypto assets, it is important for financial advisors and valuation professionals to understand how existing accounting standards are being interpreted and applied in the digital space. 1 Accounting for and Auditing of Digital Assets Practice Aid (Durham, NC: Association of International Certified Professional Accountants, 2020), 2 For purposes of the discussion in this article, cryptocurrency is limited to items that meet the Practice Aid’s specific definition of “crypto asset.” So, for example, it may not include decentralized finance, non-fungible tokens, or certain items (including cryptocurrencies) built on platforms such as Ethereum, Binance Smart Chain, Cardano, Algorand, Polygon, Fantom, Solana, or Corda. The general term, cryptocurrency, may refer to many different types of assets, software, and other technical items that do not meet the Practice Aid’s definition of crypto asset. 3 See Dave Sackett, “It’s Time to Rethink Accounting for Cryptocurrency,” Forbes, May 13, 2021, By Erin Nickell, PhD, CPA, CVA, and Philipp Schaberl, PhD Accounting for Cryptocurrency: It’s Not What You Think It Is 22The Value Examiner ValuationHow Companies Are Using Cryptocurrency Companies are currently engaging with crypto assets in two primary ways: (1) by accepting cryptocurrency as payment for goods and services, and (2) by investing in cryptocurrency directly. The number of companies accepting cryptocurrency as payment for goods and services is on the rise. Overstock, an early mover in the crypto space, became the first national retailer to accept bitcoin as payment from customers back in 2014. Since then, other major retailers—including Microsoft, Home Depot, Starbucks, and Whole Foods—have also taken the leap and are accepting cryptocurrency as payment in varying capacities. In fact, a recent HSB survey found that over one-third of small and medium-sized businesses are accepting cryptocurrency from customers.4 Perhaps the most significant way that companies are investing in crypto assets is by purchasing cryptocurrency directly. Until very recently, the notion of investing in cryptocurrency by serious investors and large public companies was considered a novelty. But with recent, billion-dollar investments by companies such as MicroStrategy, Square, and Tesla,5 this novelty is becoming a more common reality. Others, not quite ready to take on a custodial role, are opting instead to invest in funds or other companies that maintain positions in crypto assets. Other Types of Digital Assets While bitcoin and ether are certainly the most common, there are many other cryptocurrencies—e.g., XRP (Ripple), litecoin, bitcoin cash. Cryptocurrency can be purchased, received, or traded in an open market where price is determined by market participants and the laws of supply and demand. But unlike fiat currencies, cryptocurrency is unregulated, lacks physical substance, and is usually untethered to a tangible asset. For these reasons, cryptocurrencies tend to be more volatile than other assets traded in an open market.6 Other examples of digital assets include stablecoins, tokens, and Central Bank Digital Currency (CBDC). Generally speaking, the primary difference between cryptocurrency and other types of digital assets relates to functionality. 4 “HSB Survey Finds One-Third of Small Businesses Accept Cryptocurrency,” Business Wire, January 15, 5 For a list of companies with significant investments in cryptocurrency as of the writing of this article, see Stephen Graves and Daniel Phillips, “The 10 Public Companies with the Biggest Bitcoin Portfolios,” Decrypt, December 30, 6 See Neil Beaton, “Cryptocurrency: The Future of Currency or Twenty-First Century Mythical Beast?” The Value Examiner (January/February 2019): 6–12. 7 The SEC has specified that “merely calling a token a utility token or structuring it to provide some utility does not prevent the token from being a security” and under the jurisdiction of the SEC. U.S. Securities and Exchange Commission, “Statement on Cryptocurrencies and Initial Coin Offerings,” December 11, 2017, 8 “What is a Central Bank Digital Currency?,” FAQs, Federal Reserve, updated January 20, A stablecoin is a type of crypto asset that is backed by a reserve asset—deriving its value from a fiat currency or other asset—and usually less volatile than cryptocurrency. For example, a stablecoin could be tethered to the U.S. dollar, where the price for each stablecoin is set to $1. Stablecoins can also derive value from other cryptocurrencies, which are then held in a reserve to convey stability. Stablecoins vary in their ability to maintain reserves, the reliability of their reserve capacity claims, and the reliability of their stability maintenance. Crypto tokens are a type of digital asset, similar to stablecoins in that they are asset backed but the range of potential assets is broad. The functionality of tokens can also extend beyond a medium of exchange. A common type of crypto token is a utility token. Much like a gift card, utility tokens offer the holder a right to a service or product. Other possibilities include reward points, number of downloads, or hours of streaming services. Security tokens are another common type of crypto token and can be issued as a digital representation of investments in equity, debt securities, or derivatives. In general, the Securities and Exchange Commission (SEC) has held that a security token is one that represents ownership or voting rights, or entitles the holder to a share of future profits.7 Although no country has officially adopted a CBDC, the U.S. has officially announced intentions to research the implications of such a move.8 Currencies issued by a central bank, however, would operate under the control of a country’s regulatory and monetary authority. Essentially, CBDC aims to be a digital representation of a country’s fiat currency. Accounting for Cryptocurrency As of now, there is no specific mention of digital assets, crypto assets, or cryptocurrency in any generally accepted accounting principle (GAAP) laid out in the Financial Accounting Standards Board’s (FASB’s) Accounting Standards Codification (ASC). In December 2021, the FASB added “Accounting for Exchange-Traded Digital Assets and Commodities” to its technical agenda. This marks the first move by accounting standard setters toward the development of specific authoritative guidance for digital assets, such as cryptocurrency. 23March | April 2022 A Professional Development Journal for the Consulting DisciplinesIn the meantime, determining the appropriate accounting treatment for cryptocurrency has required the accounting profession to carefully consider its unique characteristics in the context of existing accounting standards. Most accounting firms have concluded9 that cryptocurrencies, like bitcoin, should generally be accounted for as indefinite-lived intangible assets under ASC 350, Intangibles—Goodwill and Other.10 Although cryptocurrency functions as a medium of exchange, similar to fiat currencies and other digital currencies, there are a few other defining characteristics that distinguish this type of crypto asset from other assets. First is the absence of a jurisdictional authority. If a crypto asset is not backed by a sovereign government and is not considered legal tender specific to a jurisdiction, it cannot be considered cash or cash equivalents under current accounting standards. Currently, only fiat currencies meet this requirement (although CBDC, if adopted, may also qualify). Second, cryptocurrency does not give rise to a contract between two parties. It may represent tender in a contractual agreement but, once exchanged, it does not result in an ongoing contractual obligation. If it is not cash and does not represent a contractual right to cash (or any other financial instrument), it cannot be considered a financial instrument or financial asset either. That is, it does not meet the definition of a “security” as laid out by the Securities Acts of 1933 or 1934. Finally, cryptocurrency lacks finite monetary value and physical substance, so it does not meet the definition of inventory. It does, however, meet the definition of an intangible asset. Accordingly, cryptocurrency should be accounted for under ASC 350 and reported on the balance sheet as an intangible asset. 9 Many of the Big 4 accounting firms have released guidance regarding the accounting for cryptocurrency and support for their interpretation of existing accounting standards. See Deloitte, “Classification of Cryptocurrency Holdings,” Financial Reporting Alert 18-9, July 9, assets under current U.S. GAAP. 10 Alternative accounting treatments for cryptocurrency may be appropriate in limited circumstances, such as when held for sale as part of an entity’s ordinary business operations when held as an investment by entities within the scope of ASC 946, Financial Services—Investment Companies. See Deloitte, “Classification of Cryptocurrency Holdings.” 11 The determination of useful life should consider factors outlined by ASC 350, Intangibles—Goodwill and Other, specifically ASC 350-30-35-3. 12 To determine the fair value of digital assets received from a revenue contract with a customer, companies should refer to ASC 606, Revenue from Contracts with Customers. 13 See the Practice Aid for additional guidance regarding unique circumstances that might arise when testing digital assets for impairment. According to ASC 350, companies must also determine whether the useful life of an intangible asset is finite or indefinite;11 that is, whether there are any factors (legal, economic, or otherwise) that would suggest a limitation to the time an asset is expected to contribute to an entity’s future cash flows. When an asset has a finite useful life, proper accounting treatment is to amortize the asset’s acquisition cost over its useful life. However, cryptocurrency generally does not have any inherent limits on its useful life. This does not mean that its useful life is infinite; just that the end of its useful life is not foreseeable. Therefore, cryptocurrency should be classified as an indefinite-life intangible asset. Next, companies must determine the amount at which the asset should be reported. As an intangible asset, cryptocurrency purchased for cash would initially be reported at cost. Alternatively, if a company were to receive cryptocurrency as a form of noncash payment from a customer, the recipient of the cryptocurrency would report an intangible asset at its estimated fair value on the date of receipt.12 For an intangible asset with an indefinite life, much like goodwill, accounting standards also require that the asset be tested for impairment at least annually; more frequently, if events or circumstances arise that indicate a significant decline in value. If an impairment indicator exists, companies must immediately recognize an impairment loss equal to the estimated excess value.13 For example, since its $1.5 billion investment in bitcoin during the first quarter of 2021, Tesla has recorded cumulative impairment losses of $101 million. Unfortunately, under ASC 350, if there is an indication that the value of the crypto As the digital landscape continues to evolve, companies can be expected to engage in commercial transactions that incorporate digital assets in new and innovative ways. 24The Value Examiner Valuationasset has risen, companies are not allowed to recognize the increase. As of the end of the third quarter, Tesla’s bitcoin investment had a carrying value of $1.31 billion, yet its fair market value was estimated at $1.83 billion. So, when market prices move in the other direction, companies will need to consider the implications of holding onto the impaired asset.14 Additional Considerations The complexity of crypto assets, combined with the absence of clear and specific accounting guidance, presents a number of challenges. Most significantly, the volatility of the crypto market and the rapidly changing landscape involves a significant amount of uncertainty. For companies invested in cryptocurrency, valuation professionals will need to consider the likelihood of future impairment charges and adjust discount rates for the increased uncertainty and risk. Analyzing a company’s cash receipts or receivables is complicated when a portion of revenue is collected in cryptocurrency. For example, in accordance with accounting standards (see ASC 606, Revenue from Contracts with Customers), cryptocurrency that is received concurrently with the exchange of a good or service is accounted for as a form of noncash consideration, measured at fair value. On the other hand, cryptocurrency that has not yet been received for revenue that has been earned would not be recorded as a receivable. Instead, companies must determine whether the right to receive cryptocurrency in the future constitutes a derivative or a hybrid financial instrument 14 See Tesla, Inc., “Note 3—Digital Assets,” Form 10-Q for the nine months ended September 30, 2021, 17. 15 See the Practice Aid for guidance regarding the recognition and measurement of cryptocurrency received by a company in exchange for goods and services. 16 Also relevant to the derecognition of intangible assets is authoritative guidance provided by ASC 606, Revenue from Contracts with Customers. that contains an embedded derivative, in accordance with accounting standards pertaining to derivatives (see ASC 815, Derivatives and Hedging).15 With the rise of decentralized finance, which uses blockchain technology to automatically execute smart contracts between entities, companies with a position in cryptocurrency may increasingly choose to lend the asset to another company. Under current accounting standards, however, both the borrower and the lender would report the asset on their balance sheets. Because cryptocurrency is generally accounted for as an indefinite-life intangible asset, lenders do not derecognize the cryptocurrency as an asset (see ASC 610-20, Gains and Losses from the Derecognition of Nonfinancial Assets),16 resulting in asymmetry between the lender and borrower. Conclusion As the digital landscape continues to evolve, companies can be expected to engage in commercial transactions that incorporate digital assets in new and innovative ways. Although most small businesses do not have to comply with U.S. GAAP accounting standards, a lack of consensus regarding how crypto assets should be reported will have implications for companies of all sizes. Further, the way digital assets are used—as an investment or medium of exchange— is inconsistent with how they are reported, as indefinite-life intangible assets. This obvious contradiction may obfuscate information that is critical to an accurate valuation. Erin Nickell, PhD, CPA, CVA, is an assistant professor of accounting at the M. E. Rinker, Sr. Institute of Tax and Accountancy at Stetson University. She earned her MSA and PhD in accounting from the University of Central Florida. She teaches financial accounting, auditing, forensic accounting, and fraud examination, and has published work on auditor decision-making, professional skepticism, and financial reporting fraud in journals such as Critical Perspectives on Accounting; Accounting Horizons; Accounting and the Public Interest; the Journal of Accounting, Ethics & Public Policy; Strategic Finance; and the Tax Adviser. Email: Philipp Schaberl, PhD, is an associate professor of accounting in the Department of Accounting and Computer Information Systems at the Monfort College of Business at the University of Northern Colorado. He earned his MS and PhD in accounting from the University of Cincinnati and his MS in business and economics from the Johannes Kepler University in Linz, Austria. He teaches financial accounting and data analytics to undergraduate, MACC, and MBA students in the U.S. and internationally. Dr. Schaberl has published his work on capital markets, valuation, and financial analysis in journals such as Journal of Accounting, Auditing & Finance; Financial Management; European Financial Management; Advances in Accounting; and The Value Examiner. Email: 25March | April 2022 A Professional Development Journal for the Consulting Disciplines Duff&Phelps_VE_Ad_Feb_2022.indd 1Duff&Phelps_VE_Ad_Feb_2022.indd 12/24/22 1:56 PM2/24/22 1:56 PMAuthor: Yanfu Li, Chengdu Technological University. Source: Review of Business & Finance Studies 12, no. 1 (2021): 79–89, Academic Research Briefs By Peter L. Lohrey, PhD, CVA, CDBV This column provides summaries of contemporary research in valuation and forensic accounting. Summarized articles and manuscripts—selected from numerous academic research outlets—cover significant developments that affect the ever-changing valuation and forensic accounting landscape. The objective is to increase awareness of recently completed research that advances knowledge of these subjects. Note: References cited in these reviews are not listed here, but are available in the articles or manuscripts being reviewed. As this column evolves, The Value Examiner encourages readers to forward relevant manuscripts or working papers for consideration. Please send links or files with Academic Research Briefs in the subject line. Improving the Accuracy of Estimated Intrinsic Value Through Industry-Specific Valuation Models Summary 1 It should be noted that Li breaks what he calls the financial industry into three segments: commercial banks, insurance, and securities. He also breaks down what he calls the information technology industry into two segments: software and computer services, and technology hardware. Li attempts to improve the accuracy of an estimated intrinsic value by creating an industry-specific valuation model. This relies on the fact that various industries possess distinctive features. Hence, Li reasons that different valuation models should be used for different industries. He develops this premise further by arranging two industries that are examined in this study—namely, the financial and information technology industries1—according to what he calls the Industry Classification Benchmark. Li suggests a sequence of matching valuation models for each of the sectors he defines within each industry. He concludes by asserting that use of a more compatible valuation model will yield a better estimate of intrinsic value. Motivation for the Study Li begins by pointing out that stock analysts have not reached a general consensus about what the standard should be for selecting a specific valuation model for a given industry. In many cases, they prefer different valuation models for the same industry. This in turn leads to a variety of valuation models being used for one industry, and the resultant inconsistent valuation conclusions, which lowers the public’s confidence in the dependability of different valuation estimates. Li highlights the fact that most studies that examine valuation models tend to focus on comparing the performance of different valuation models. He believes there is not very much published research that studies the relationship between the various characteristics of a given industry and the compatibility of a given valuation model. Li’s study attempts to illustrate how the use of a more compatible valuation model that utilizes his Industry Classification Benchmark provides a more accurate estimate of intrinsic value for the financial services and information technology industries. Industry-Specific Models Financial Services—Commercial Banks Commercial banks generate most of their income from the spread between interest rates they pay to depositors and the interest rates they charge to borrowers—both commercial and individual consumer loans. It should be noted that barriers to entry for commercial banks are high, as the governments in most countries regulate them. Also notable is that the fixed assets of commercial banks are much lower as a percentage of total assets in comparison to other industries, such as manufacturing. This small capital foundation causes commercial banks to be extremely 27March | April 2022 Academic Reviewsusceptible to losses from bad loans. Hence, they are required by regulators to maintain an adequate capital ratio by ensuring that there is enough equity on the balance sheet. Li states that Damodaran (2009) believes that debt should be perceived as the raw material that commercial banks use to earn money. Fink (2012) asserts that equity-based multiples should be used to value commercial banks because they ignore debt and unpredictable cash flow, thereby focusing on the equity capital of the commercial bank. Imam et al. (2008), on the other hand, believe that price-to-book value is the best valuation model for the commercial banking industry. Damodaran (2009) agrees with Imam et al., pointing out that book value is a reliable measure of current value due to the mark-to-market accounting rules for commercial banks’ capital. Finally, Li points out that the more conservative a commercial bank is, the greater the amount of loan loss reserves. This leads to lower levels of earnings, so that earnings do not reveal the real performance of a commercial bank. He concludes that stock analysts should focus on price-to- book value and put less emphasis on price to earnings (P/E) multiples for commercial banks. Financial Services—Insurance Li states that several academic studies define insurance as the equitable transfer of risk of loss from one entity to another in exchange for payment. Insurance companies earn profits from the spread between the return on invested assets and the claims paid to policy holders. Nissim (2013) states that discounted cash flow (DCF) models cannot be used to value insurance companies, because they focus on operating activities and the cash flows from the investment portfolio are highly unpredictable. Li asserts that dividend models, such as discounted dividend and dividend yield, only slightly outperform the 2 Dong (2008) defines embedded value as adjusted net worth plus the value of in-force business. DCF model. To address these problems, Damodaran (2009) suggests adding any stock buybacks made by management to the dividends paid in order to determine the composite payout ratio. Nissim (2013) examined the accuracy of a series of relative models used to value U.S. insurance companies and found that book value multiples performed significantly better than earnings-based multiples. Finally, Li points out that Dong (2008) found that the best model to use to value insurance companies measures the intrinsic value as the sum of embedded value2 and the present value of future new business. He closes the discussion of insurance company valuation by stating that the appraisal value model is complicated and has not been widely used by research analysts, yet it is ideal for a strong growth life insurance company because it considers values from the net asset, existing business while simultaneously including any new business. Financial Services—Securities Li defines securities companies as investment banks or brokerage houses that offer securities brokerage, investment banking, and asset management services while actively partaking in proprietary trading. Separate from commercial banks and insurance companies, their stock price performance is closely related to stock market movements, so they tend to have significant positive betas. When valuing securities companies with significant growth opportunities, traditional valuation models, such as P/E multiples, can be quite unstable. Further, trailing earnings should not be relied upon to estimate future earnings or risks that lie ahead. As a result, Iman et al. (2008) emphasize the role that earnings growth rates play in determining the fair value of a flourishing company. Table 1 summarizes Li’s recommended valuation models for the financial industry. Table 1: Recommended Valuation Models—Financial Industry SectorRecommended Valuation Model Commercial banksPrice-to-book value, price-to-earnings, residual income InsurancePrice-to-book value, price-to-earnings, appraisal value SecuritiesPrice-to-book value, price-to-earnings, P/E-to-growth 28The Value Examiner Academic ReviewInformation Technology—Software and Computer Services Li defines the software and computer services segment as a grouping of information technology firms that provide the research, development, and distribution of information technology-related products and consultation services. The balance sheets for these companies contain many intangible assets. Consequently, technology and its value make up most of the intrinsic value found on these companies’ balance sheets. The core technologies owned by these firms are quite often unique, which prevents them from comparing their technologies to those of the other firms in this segment of the industry. Thus, Thornton et al. (2011) stated that relative valuation models do not do a better job than absolute valuation models for determining the fair value of companies that operate in the software and computer services segment of the information technology industry. In addition, both Pinto et al. (2020) and Demirakos (2004) believe that accounting measures are less relevant for intangible-intensive businesses. The reason for this is that current accounting rules require many research and development (R&D) investments to be expensed in the period when they occur. This causes book value to be misleading when trying to use it for companies with large R&D investments. Li explains that complex DCF models that are capable of estimating intrinsic value as the present value of projected cash flows have been determined to be the best way to value software and computer services firms. It is important to note, however, that the best valuation model to select will vary based on the life stage (start-up, growth, or mature) the target company is in. For start-up companies—most of which are not listed on a stock exchange—there are few, if any, comparable listed firms, so their market capitalizations or market prices will usually have to be estimated by examining comparable transactions. Thornton et al. (2011) assert that future earnings and their growth rates are very hard to estimate, for their accounting records are not very reliable. Hence, Zhang et al. (2010) believe that the modified discounted cash flow (MDCF) model, which uses several indeterminate components, is the soundest model available. The primary reason for this is that several different scenarios can be used on a probability-weighted scale. For growing companies whose earnings have moved into positive territory, their earnings become more consistent and less 3 Porter’s Five Forces is a business analysis model that helps explain why various industries are able to sustain different levels of profitability. See Michael E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press, 1980). volatile. Hence, earnings become a more reliable determinant of value. Further, as these companies undertake a variety of ways to finance further growth, their capital structures will vary. Therefore, Pinto et al. (2020) recommend that enterprise value-to-EBITDA becomes a better valuation metric than the P/E ratio to compare companies with differing degrees of financial leverage. For mature companies, the business risk falls sharply, thereby significantly reducing the need to use the MDCF model. So, at this point in the company’s life cycle, the traditional DCF model returns to become the best measure of value. One of the primary reasons for this is that mature companies have limited reinvestment opportunities. In addition, the earnings for these companies tend to be stable, so earnings-based measures, such as the P/E ratio, will provide accurate estimates of value. Information Technology—Technology Hardware Apart from the software and computer services sector, the technology hardware sector is more traditional, and thus more capital-intensive, leading to greater barriers to entry for start- ups. This in turn leads to a greater following by equity analysts. Li states that, generally speaking, the technology hardware sector includes companies that develop, manufacture, and distribute a wide variety of hardware, such as communication and medical equipment, computers, technical instruments, and both industrial and consumer electronics. Li states that product differences cause the types of firms to be widely varied. He separates technology hardware firms into two classes based on upstream versus downstream on the industry supply chain. The first category consists of capital-intensive businesses, which include upstream firms that manufacture electrical parts and accessories along with downstream firms that do not possess significant R&D capabilities. The second category contains upstream firms that produce integrated circuits and computer chips, as well as downstream manufacturers of finished products. This category is both capital- and technology-intensive. Li proceeds to analyze the different types of technology hardware firms through the lens of Porter’s Five Forces theory.3 He then proceeds to recommend a series of appropriate valuation models. For capital-intensive businesses, such as manufacturers of electrical parts and accessories, there is a meaningful threat of new 29March | April 2022 A Professional Development Journal for the Consulting DisciplinesNext >