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Testing Corporate Decision-Making Systems To Judge the quality of a corporate decision-making system, begin by considering the four elements of corporate decision-making: objective and alignment, risk and uncertainty, usability (simplicity, speed, flexibility), and communications and transparency. Then apply the following three essential tests: 1. Does it match Wall Street valuations? 2. Does it match Market valuations? 3. Does it match the relevant information? Wall Street Valuations Wall Street values derivatives (e.g., options) of market-tradedassets like stocks by removing any arbitrage opportunities. Arbitrage opportunities occur when a trader can make money with no risk, for example, by buying corn in Chicago at one price while simultaneously selling that corn in New York for a higher price.Obviously, these opportunities are rare and don’t last long. At any instant, owning an option on a stock is equivalent to owning both some fraction of that stock and some fraction of a risk-free bond. In essence, the arbitrage trader could replicate the option by buying the stock and bond. The purchase fractions are nearly continuously changing yet the value of that option will always stay extremely close to its equivalent value in terms of stock and bond because otherwise there would be an arbitrage opportunity for a trader. The exact value of a simple call option on a stock (option to purchase the stock at a pre-set price) was solved analytically by Fischer Black and Myron Scholes resulting in the famous Black-Scholes formula. Robert Merton made the observation that the removal of arbitrage was necessary for the proper interpretation of the solution. Scholes and Merton won the 1997 Nobel Prize in Economics for their work (Black passed away in 1995). Removing all arbitrage opportunities is a requirement of any consistent, accurate decision framework, but is not sufficient for valuation and decision-making outside of Wall Street. Almost all strategic decisions have uncertainties that are nonreplicable, i.e., uncertainties for which there are no market assets that a trader could buy or sell to get an equivalent ownership. Therefore, maximizing the goal of the decision-entity becomes essential. Market Valuations The goal of a publicly-traded corporation is to maximize True Shareholder Value. For a publicly-traded corporation, the goal is clear and always the same. Any other goal would violate the fiduciary duty of the company, in spirit and perhaps even legally. Market-traded assets are valued by considering how they contribute to the Market, which has significantly variable future payoffs. That is, the valuation of the company to actual or potential shareholders is made with knowledge of the existence of the Market. Investors also have the option to invest in risk-free bonds and have shown a preference for larger and more certain payoffs. Therefore, we expect that the Market will have an average future growth rate that is higher than the risk-free rate. For decisions and valuations that can be made using replication techniques, maximizing True Shareholder Value leads to the same decisions and valuations. A corporate decision-making system must have the appropriate goal and the ability to properly include any available Marketinformation. More than that, it must be able to include any type of relevant information. Relevant Information The best corporate decision-making system will incorporate all types of relevantinformation properly. This implies that a decision-maker will not be forced to translate their information or to enter information they don’t have, and that no other information will be added that doesn’t exist, whether explicitly or not. Information comes in many forms, including human experience and knowledge as well as computer data and analysis.
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