Academic journal article IUP Journal of Applied Finance

Rating and Ranking Firms with Fuzzy Expert Systems: The Case of Camuzzi

Academic journal article IUP Journal of Applied Finance

Rating and Ranking Firms with Fuzzy Expert Systems: The Case of Camuzzi

Article excerpt

(ProQuest: ... denotes formulae omitted.)


This study presents an expert system aimed at evaluating firms. To this end, the lines of reasoning of experts are replicated, taking into account the financial, business, and strategic determinants. The approach followed results in a method of rating and ranking firms. The model presented may also be used to ascertain the impact of a particular management's decision on value creation or to compensate managers on the basis of their performance. The model has been applied to the case of Camuzzi, recently acquired by Enel, the Italian ex-monopolist of electric energy.

The evaluation derives from the use of 'if-then' rules in a fuzzy logic environment. While our approach is just a first attempt to develop a new methodology for appraising firms and business units, we think that this path is fruitful for dealing with complex situations where a great number of value drivers must be taken into account, both qualitative and quantitative, and/or where explicit account of their interrelations must be taken for a better description of the evaluation process.

While it is an alternative to DCF techniques, the structure of the model proposed here is logically consistent with it as well as with a strategic management conceptual framework. As for DCF techniques, the standard computation of the enterprise value is given by the present value of the free cash flow to firm:


where FCFFt= FCFFt-1 (1+g) and FCFF 1 = FCFF with FCFF = Free Cash Flow to Firm, g = growth rate, WACC = Weighted Average Cost of Capital. The WACC is an opportunity cost, representing the foregone return of alternative businesses in the same class of risk (usually in the same sector), and is an increasing function of risk. The value also increases with respect to both FCFF and g, and it decreases with respect to risk. An equivalent way of computing the market value of the firm is the Adjusted Present Value (APV) method introduced by Myers (1974) (see Fernandez, 2002):


where kU is the cost of equity of the unlevered company, DVTS is the discounted Value of Tax Shield. Consistent with this approach, the output of our expert system depends on free cash flows and growth (positive correlation) as well as on operating risk (negative correlation).

The DCF technique is a black box where the determinants of FCFF and g are not highlighted and where risk appears only implicitly in the rate kU (or WACC), whereas our model explicitly takes account of these variables. Further, the DCF methodology seems to be unsuited for quantification of synergies, and if a quantification is ever attempted, the analyst just raises discretionally the FCFF. In our approach, we explicitly consider synergies as an important determinant of rating, and explicit relations between synergies' determinants are stated via a specific rule block.

In other terms, the rigorous way of discounting cash flows adopted by the DCF approach is offset by a nontransparent way of fixing the value for FCFF and g. The determination of these inputs is left to the analysts' or managers' arbitrariness, thus causing possible manipulations of data. Our model does retain the conceptual frame of the DCF approach, but integrates it with strategic management theories. For example, the presence of resources and skills as a value driver is coherent with the findings of the resource-based view according to which a variety of peculiar skills and intangible abilities can greatly affect a firm's performance (Barney, 1986 and 1991; Grant, 1991; Levinthal, 1995; and Barney, 2001). Likewise, the variable barriers, customer concentration and supplier concentration give expression to Porter's (1980 and 1985) industry analysis.

The integrated view we propose is also consistent with bounded rationality in that preeminent importance is given to recognizing limited computational capabilities and presence of constraints. For example, the presence of value driver management quality in our model is consistent with the literature on Top Management Teams (TMTs) which claims that managers and employees differ in expertise so that the quality of the TMTs decisions substantially influence the performance of the firm (Bromiley, 2005, p. …

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