What are Unobservable Inputs?

Unobservable Inputs

Unobservable inputs refer to the valuation inputs for an asset or liability that are not readily available in the marketplace and cannot be derived from observable market data. These are estimates or assumptions that a company makes based on the best available information, which often come from the company’s own data or internal models. Unobservable inputs are used in various financial modeling techniques, including discounted cash flow analysis and other valuation methods.

Types of Inputs in Valuation Models

Valuation models often use a mixture of inputs that can be classified into three broad categories based on the U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS):

• Level 1 Inputs: These are observable inputs that reflect unadjusted quoted prices for identical assets or liabilities in active markets.
• Level 2 Inputs: These are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. This might include quoted prices for similar assets or liabilities in active markets or inputs like interest rates or yield curves that are observable at commonly quoted intervals.
• Level 3 Inputs: These are unobservable inputs for the asset or liability, used when little or no market data is available. Companies must make their own assumptions about the variables that would be used by a market participant in pricing the asset or liability.

Importance

The use of unobservable inputs can introduce a greater degree of subjectivity and estimation uncertainty into the valuation process. That’s why companies are often required to disclose the extent to which they use unobservable inputs to value assets and liabilities, and the methods and assumptions used in their models.

Example of Unobservable Inputs

Let’s delve into a simplified example to illustrate the concept of unobservable inputs.

Example: Valuing a Unique Software Product

Imagine you are the CFO of a tech startup that has developed a unique software product for machine learning applications. Since there are no identical products or active markets for this specific type of software, you have to rely on unobservable inputs to value it.

Unobservable Inputs Used:

• Estimated Future Cash Flows: Based on your market research, you estimate the software will generate cash flows of $1 million in the first year, growing by 20% annually for the next five years.
• Discount Rate: You estimate a discount rate of 12% based on the company’s weighted average cost of capital (WACC), adjusted for the risk associated with this new software.
• Market Penetration and Growth Rates: Your marketing team estimates a market penetration rate of 10% in the first year, increasing by 2% each subsequent year.

Valuation Method:

You decide to use a Discounted Cash Flow (DCF) model to value the software product.

1. Calculate the Estimated Cash Flows:

• Year 1: $1 million
• Year 2: $1.2 million (20% growth)
• Year 3: $1.44 million (20% growth)
• Year 4: $1.728 million (20% growth)
• Year 5: $2.0736 million (20% growth)

2. Apply the Discount Rate to Future Cash Flows:

• The present value of these cash flows is calculated using the 12% discount rate.

3. Final Valuation:

• Summing up these discounted cash flows will give you the estimated value of the software product.

Disclosure:

Due to the subjective nature of the unobservable inputs, your company would be required to disclose the methodology and assumptions behind the valuation in its financial reports. This disclosure helps investors and stakeholders understand the risks and uncertainties associated with the valuation.

Potential Pitfalls:

• Estimation Error: The value is highly sensitive to the unobservable inputs. A slight change in estimated cash flows or discount rate can have a significant impact on valuation.
• Subjectivity: The use of unobservable inputs introduces a level of subjectivity and uncertainty that stakeholders must be aware of.
• Regulatory Scrutiny: Because these are Level 3 inputs under GAAP and IFRS, they may attract more regulatory scrutiny and could require external auditing or verification.

This example demonstrates how unobservable inputs can play a critical role in the valuation of unique or illiquid assets, and why these valuations often come with a high degree of uncertainty and risk.