Unfair Value

By Joshua Maggid (2009, actuary-info)

How can you be against something that's fair, like "Fair Value"?
What could be wrong, valuating a company at market value?

IceComp Case
Let me take you along in a story about IceComp, a fictitious ordinary wholesaler in ice creams.

The daily demand for ice creams turns out to be in line with the outside temperature. In an average
summer, with an average temperature of 16°C (about 60°F), IceComp sells 10 million ice creams a
year. Annual turnover the past 10 years, $ 20 million with a net margin of 10%.

In order to regulate demand and to maximize profit, IceComp defines the daily ice cream selling
price (P) in line with the market by the formula:
P = DAYTEMP / 8
So at 32°C an ice cream will sell at $ 4 and at 16°C it will sell at $ 2 a piece. To always deliver on
time, IceComp keeps an average stock of about 2 million ice creams. Based on on the average
selling price of the last 10 years, this stock is valued in the balance sheet at $ 4 million, resulting in
a fair and trustworthy P&L, that reflects the actual sales level at current prices.

Two years ago, inventory (stock) valuation based on market prices ('fair value'), i.e. the price daily
selling price of an ice cream, became mandatory. From that moment on, things started to go wrong.

Consistent with the daily temperature, the daily inventory value starts to oscillate heavily, with
explosions and variations up to $ 6 million per month. To the 'surprise' of all stakeholders, equally
strong alternating monthly gains and losses are reported. It's crystal clear, the company is no longer
'in control'.

The national supervisor interferes and demands extra securities (funds). Now the monthly P&L of
IceComp starts to oscillate even more, as the investment results of the extra securities, that
principally do not have anything to do with the core business of IceComp, also start to vary on basis
of 'fair value' (market prices) valuation. Ultimately, lack of confidence from share- and
stakeholders drives IceComp into bankruptcy.
Conclusion
What was meant to be 'intentional Fair', turns out to
be 'Unfair' in practice. Valuing balance sheets on
bases of daily prices is like playing 'Russian
roulette'. It can be compared to making 'climate
statements', based on the daily weather forecast.

The analogy to banking, pension and insurance

business may be clear. Don't base valuation
methods on daily prices, but on a, per product or
market defined, 'moving average market price' for a
fixed chosen period (depending on product or
market cycle).

The current (credit) crisis calls for development of new adequate and stable valuating principles.