Are Business Valuators Biased? The Case of the Discounted Cash Flow Method
A company's value is derived from expectations regarding its future cash flows.
Therefore, valuation theory is predominately focused on the concept of capitalizing or discounting future earnings. Although there are different valuation methods, a widely accepted and common valuation method is the Discounted Cash Flow method (DCF). The DCF method consists of two main variables. The first variable concerns the company's estimated future free cash flows (i.e., cash that is not required for operations or reinvestments). The second variable concerns the 'discount rate' that reflects the estimated free cash flows' riskiness. Given these two variables, applying a relatively simple equation enables one to find a company's value.
TAt first sight, the DCF methodology seems a simple and elegant solution. In practice, two or more business valuators, who value the same company, might find various values for the same company. Sometimes the difference between the values can even reach hundreds of percent.
Regarding the theory of valuation, it was found that the valuation process is affected by two biases - anchoring and engagement biases
What is the cause of the value gap?
In the case of a minor difference in outcomes, usually are different assumptions in the valuation framework. This difference may be due to the foundations of the discounted cash flow method. Large differences, however, are problematic and difficult to explain.
Implementing of the DCF method is a lack of clear guidelines, as well as consists. In several cases, the difference is due to timing. In times of high uncertainty, the risk increases, causing a lower value. In other cases, the valuation's objective - whether the purpose of the valuation is for buying or selling may drive the adoption of different assumptions.
A new study found that there might also be another reason - a psychological one - a cognitive bias. A cognitive bias is a systematic pattern of deviation from norm or rationality in judgment. Individuals create their own "subjective reality" from their perception of the input. An individual's construction of reality, not the objective information, may dictate their behavior in the world. Thus, cognitive biases may sometimes lead to perceptual distortion, inaccurate judgment, illogical interpretation, or what is broadly called irrationality.
In the early seventies of the twenty century, Tversky and Kahneman found that in situations characterized by high degrees of complexity and uncertainty, human judgments are affected by heuristics and biases. Since then, it was proved that biases might affect financial decisions and predictions.
For example, it has been established that financial decisions are plagued by overconfidence on behalf of decision-makers, and investment strategies are influenced by over-optimism.
Regarding the theory of valuation, it was found that the valuation process is affected by two biases - anchoring and engagement biases.
Anchoring is a cognitive bias where an individual depends too heavily on an initial piece of informationת he was exposed to. The initial information is called an "anchor". Regarding valuation, an anchor can be, for example, the last year's firm value. Valuators are affected by anchoring bias when judging the value of a company, such that they will determine a higher value following a high anchor and a lower value following a low anchor.
Engagement is another bias. When professionals are affected in their judgments such that they favor their clients' interests. Regarding valuation - valuators are affected by engagement bias when judging the value of a company, such that they will calculate the value in accordance with their clients' interests.
