Tuesday, March 1, 2011

Behavioral Economics: Thoughts on Value and Price

I must confess that I was a skeptic on behavioral finance until a few years ago. At that point, the amount of information that had been accumulated on the "irrational" behavior of investors became so overwhelming that I faced one of two choices. I could ignore reality and live in the clean, rational world of classical economics or I could face up to facts and think about how investment and corporate finance decisions should be made in the messy world that we live in. After struggling with the conflict, I think I am making some progress. In an earlier post  on the third edition of my corporate finance book, I noted my attempts to incorporate the findings from behavioral finance into every aspect of corporate finance from how to create effective boards of directors to capital budgeting and capital structure decisions.

Reconciling behavioral finance with my view of the world has been tougher in my other area of interest: valuation. Every semester that I teach the valuation class, using the tools of the trade (discounted cash flow models, relative valuation), I am asked how I would incorporate the findings from behavioral finance into valuation. Here is my reaction. I don't think intrinsic valuation approaches will change much, if at all, as a result of behavioral economics. The expected cash flows are still the expected cash flows and  the required return still has to reflect the perceived risk in the investment.

So, what does change? Remember that to make money of your valuations, not only do you have to be able to value assets but the price has to move towards that value. Behavioral economics provides us with interesting insights on three dimensions:

a. Why do different analysts arrive at different estimates of value for the same company?  When you value a company, you are one of many doing so, often drawing on the same information as other investors, and often using the same models. So why do different analysts arrive at different estimates of value?  By looking at the interaction between psychology and valuation, behavioral economics yields interesting insights into why the values that we arrive at are different (and by extension, why some of us are buyers and others are sellers) and the systematic errors (over valuation or under valuation) that we make as a consequence.

b. Why does price differs from value? In the classical world, the price can deviate from value because investors make mistakes or because the price may reflect information that the analyst may not have or vice versa. With behavioral economics, we are learning that even if investors may behave in ways (refusing to sell losers, wanting to be part of the crowd, being over confident and misassessing probabilities) that cause prices to diverge from value by significant amounts.

c. When will they converge? Behavioral economics may provide us with clues about how quickly convergence between price and value will happen and why the speed may vary across assets. That would be incredibly useful to an investor. Thus, we may be able to answer a question that has historically eluded us: If I buy a cheap stock today (and I am right about it being cheap), how long do I have to wait before my bet pays off?

As investors, it behooves us to not only become conversant with the findings in behavioral finance but to also recognize when following instinct can damage portfolios. Meir Statman, one of my favorite behavioral economists, has written a great book on how investors can overcome their base urges and make better decisions:
I hope you get a chance to read it. There is much work to be done, but the foundations are being laid.


Mike said...

Prof, interesting article. I will try to get the book.

In my opinion, the following traits describe the Wall Street behavior:

Greed, Deception, the Greater Fool theory, and not to forget Washington, Wallstreet collusion .

MihaiP said...

I feel this is coming on the right path, but at the limit would be that the for a given complex "thing" e.g. a company, the valuation (value, not price) will be different for each and every of us, because we have perceived the world with different experiences which will influence the assumptions underlying the models.

But if that so, would the valuations really help in pricing? And the answer has to be yes, as most often the valuations are not a number, rather an interval, where most of the valuations from different people are expected to be.

The major point that behavioral science brings is that of the mistake, so that any one analysis can be wrong, but many independent analysis showing largely similar valuations should be not. One question arising from this - are generally the analysis really independent?

tom brakke said...

"The expected cash flows are still the expected cash flows and the required return still has to reflect the perceived risk in the investment."

I think you're missing some key behavioral influences here. The assessment of future cash flows is definitely a behavioral exercise, subject to all sorts of traps. And the decision on the required return to use, unless done in a mechanistic fashion (which brings in a host of other errors), also is subject to behavioral errors.

The process of valuation is rife with behavioral issues. That doesn't make it not worth doing, it just means that it has to be approached in a different manner than many practitioners do.

Aswath Damodaran said...

You are right. The way we form expectations and adjust for risk can be skewed by behavioral components. However, there is a underlying truth that will ultimately come out. So, the key to doing valuations is first being aware of your own behavioral impulses, how they play out when you do valuation and how to counteract them.

Mike said...

Hi Professor,

Do you see any behavioral thingie in the recent 'Facebook valuation' by Goldman Sachs? What was in play when GS estimated the cashflow and discount rate?

Unknown said...
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Unknown said...

Another great treatise on behavioral finance that one could read would be the classic "Manias, Panics, and Crashes" by the late Charles Kindleberger. I think behavioral economics is especially useful in detecting signs of bubbles, which can save investors who find them in time a ton of capital.


pflood77 said...

On share buy backs: I an easily see how share buy backs put money back in to shareholder hands when companies can not find viable investments. But using debt to fund the buy back to repurchase shares seem like destruction of value to equity holder- I am looking at your Applied Corp. Fin. (2011) pp. 411-414 Equity value in your example drops from 45,1 to 38,8. How does buy backs really create value in $. terms? - even as your share price goes from 24.34 to 25.50. ? Having a difficulty reconciling this . Thanks - Paul

Aswath Damodaran said...

The gain in value is coming from the tax laws which are tilted in favor of debt over equity. While bankruptcy cost may eventually override the tax benefits, at least up to moderate amounts of debt, the government in effect subsidizes you... Should it? That is a different question and well worth examining...

Unknown said...

Warren Buffett is an investor. Given his long-term results he can, obviously, be considered the best investor in the last 50 years. Not bad, considering that there are around more than 50.000.000 investors trying to beat him.

Corollary: to beat consistently all the other investors, he has to either be more intelligent than any other else or to have better models than any other else.

I personally prefer to think he has better models, as he and Charlie Munger have systematically explained to us.

You, Professor. Do you have any long term performance in the investing world (either you personally or through any person you have helped) better than Warren Buffett?.

If the answer is not: please improve your models.

If the answer is yes: I would very happy to listen from you the specific models you have used in beating Warren Buffett

JS Shikalepo said...

Hi prof, i have question (perhaps not related to this article) with regards to mergers and acquisitions: Is there a way (out there) to determine both stand-alone and with synergy value of a target company through multiples? Many thanks, Jay.