Neglected Existential Risks and Valuation Shocks

The emerging story of scandal over quality control at Kobe Steel illustrates an important element of strategic risk governance. Aside from the specific failures in management, leadership, and corporate culture that underpin the scandal (all elements for which the board of directors must ultimately bear accountability), there is also the instructive response of the financial markets.As reported in the Financial Times, the cost of Kobe Steel’s five-year credit default swaps quadrupled over two days. What this means is that the financial markets have priced in a very different assumption about the continued creditworthiness of Kobe. Bearing in mind that, as yet, there have been no direct financial consequences from cancelled orders or regulatory intervention (as for example we have seen over time in the case of the VW Dieselgate scandal), this market correction is wholly based on an updated view of Kobe Steel’s future ability to meet its obligations, and, quite possibly, its future survival as an independent entity.

The fact that the financial markets have reacted in this manner to new information is unremarkable. However, what this reaction illustrates quite dramatically is that the present value of an enterprise is normally based on the unstated but critical assumption that it will survive. Such an assumption is not of itself unreasonable, but it is nonetheless an assumption of an outcome that is, in reality, uncertain.

Whilst financial markets strive to “price in” the risk to future cash flows, the large corrections such as we have seen in the case of Kobe show that existential threats to a company’s survival are unlikely to be fully priced, and can wreak valuation havoc when they appear.

To avoid this, boards and management teams must to a better job of anticipating, assessing, and adapting to these threats, and, crucially, clearly communicating the effective operation of these processes to shareholders and analysts.

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