Wednesday, January 28, 2009

Bias in Valuation

I kicked off the valuation class with a discourse (actually, more of a rant) about the bias in the valuation process and how it skews numbers. I firmly believe that bias is, by far, the biggest enemy of good valuations and that it is pervasive. By bias, I am referring not only to the preconceptions we bring into the valuation of a company but also to the payoff to doing the valuation. He who pays the prices sets the bias in motion, and the valuation reflects it. Thus, if I were an investment banker hired to value a target company in an acquisition, I am going to bias my value upwards, since I make money if the deal goes through but not if it does not. I am sure that Pfizer has an investment banking valuation of Wyeth, right now, that backs up their bid.  In class today, I set up 12 different valuation scenarios and asked for guesses on the direction of the bias. Here is the link to the list:
Make your best guesses... Visit my web site for the answers.

So, what is the cure for bias? I am afraid that there isn't one. However, we can reduce bias by changing the process by which we pay for valuations. 
1. No deal maker should ever be asked to analyze whether the deal makes sense. This is what we ask of investment bankers in acquisitions. The process will create bad valuations. I think that acquirers should pay a third party (one that makes money only for doing appraisals) for the valuation.
2. In legal processes, we should have less adversarial valuation, where the expert for one side comes in with a high number and the other side with the low number and the court splits the difference.
3. Trust, but verify. Even the biggest names in the business - Goldman, McKinsey - are susceptible to bias. 

As someone who looks at other peoples' valuations all the time, what experience has taught me is that the most critical questions to ask in assessing  a valuation are: Who paid the appraiser to do the valuation? What are the potential sources of bias? That tells me a great deal more than perusing the numbers.


aymru said...

Dear Aswath sir,

I couldn't get the PDF file by clicking on the link. The link seems to be broken.

Can you please resend the link?

Nick said...

The link worked for me.

aymru said...

Yeah Link is opening now.
Thanks a lot.. :)

Joy said...

Dear Prof Damodaran

I thoroughly enjoy reading your thoughts on the recent developments in the market and its impact on valuation and investments.

On a separate note, I have just taken a look at your valuation bias test and would like to find the answers. Please advise on where I can locate it on your website.


mpc said...

How do you address the over-confidence and anchoring biases which result from conducting a valuation? That is, once an analyst conducts a valuation, he or she tends to believe in that assessment adamantly.
Thank you.

Aswath Damodaran said...

Analysts are human beings and will be subject to all of the behavioral biases that have been chronicles elsewhere. I don't know what you mean by counter them: after all, you don't have to change their minds... you just have to adjust their valuations.

Mary Adams said...

I couldn't agree more on the bias in valuations. I know from experience how much numbers can be manipulated. That's why I keep wondering about the current conversation of "fair value" in accounting. If there is a market setting a value, it makes sense. But, more often than not, valuations (and spreadsheets) get mixed up in the equation. Then you can be creating a monster.

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