Managing Cognitive Bias in Business Valuation

The process of company valuation is generally seen as a systematic financial process. The valuator studies past financial statements, creates projections, selects a suitable valuation technique, looks at market multiples, selects a discount rate, and finally reaches the company’s value. However, there is more to this valuation process than the mathematical part; there are several judgments involved.

This is especially crucial since the value of a business cannot always be observed in many instances. For instance, in the case of a private business, there is no market quotation indicating the value of the enterprise. Value will therefore have to be derived from expectations of future cash flows, comparable, transactions, asset base, risks, among others. Cognitive biases can affect the choice and interpretation of the factors above and may result in two professionals coming up with significantly different answers even when using similar approaches.

Thus, it is not a matter of implying that valuation specialists act irrationally. It is a matter of acknowledging that professional judgment is a critical element of business valuation, and it is necessary to have a proper process of valuation which takes into account the psychological aspects which may affect the process of professional judgment.

Anchoring and Confirmation Bias

The other major risk associated with company valuations includes anchoring, where undue importance is given to some initial figure like management’s estimated sale price, a prior valuation estimate, the price from some recent transaction, or the shareholder’s own perception about the value of the firm. Once that figure acts as the anchor, it becomes easier for assumptions to gravitate around that figure. For instance, once management thinks that their firm has a value of EGP 1 billion, figures relating to revenue growth, EBITDA margins, peer comparison ratios, or even the discount rate will be chosen to align with the same.

This could be made worse by confirmation bias, in which case the valuer places more importance on information that backs up the original assessment and less importance on information that contradicts the original assessment. If an organization is first considered to be a high-growth firm, then the valuer will place more emphasis on favorable information about industry trends and management expectations but pay less attention to shrinking margins, concentration of customers, competition, or past performance that may have been disappointing. A good valuation starts with the facts.

One effective method to reduce these biases is to have an independent benchmark for valuing the business, prior to looking at management’s target value, or a past valuation, among other reference points that could lead to anchoring. Assumptions must be clearly laid out, along with evidence supporting those assumptions, as well as contrary evidence. An additional way to identify whether or not the conclusion is still reasonable without the reference value would be through independent benchmarking and analysis.

Optimism and Conservatism Bias

Valuation using the DCF model is highly susceptible to the assumptions made about revenue growth, EBITDA margin, capital expenditures, working capital, and terminal growth rate. Being overly optimistic could result in the acceptance of very aggressive management forecasts without being questioned adequately, especially if the valuation is performed for the purposes of an IPO, fundraising, sale, or capital increase. On the other hand, being overly conservative might result in undervaluation simply because it seems to be more prudent.

Neither an overly optimistic nor conservative approach results in a superior valuation. The task is to identify assumptions which are realistic and defensible, having taken into consideration past performance, industry dynamics, market conditions, operational capacity, and management performance. A robust valuation exercise should be designed such that management’s forecast is put to test against past budgeting and performance figures, industry growth rates, and operational capacity, among other factors.

Optimism and conservatism bias need to be countered systematically and not based only on the individual valuer’s knowledge about these biases. The management forecasts must be reviewed against their actuals, along with other industry benchmarks, operational capacity, and market factors. Supporting evidence must back up all material assumptions, while sensitivity analysis needs to be done for the valuation of the company with changing assumptions. By considering various scenarios such as base, downside, and upside, one may make sure that the selected conclusion does not come from overly optimistic or conservatively biased views of the business.

Recency and Availability Bias

A company valuation can be misleading where the impact of recent and/or significant events is allowed more consideration than they deserve economically over time. Recency effect can make a valuer extrapolate unusually high revenues or profitability in a single year, while a short-term negative event could result in an overly negative projection. The same way, a recent high EBITDA multiple acquisition will have undue influence on the selection of market data.

This is especially important for normalized earnings and EBITDA sustainability. Any single year can be affected by abnormal income, abnormal expenses, temporary margin improvement, or other abnormal working capital activity. Therefore, valuers need to look at multiple years of financial results and separate those effects caused by structural change from temporary events in order to incorporate recent results in the valuation.

The above-mentioned bias can be mitigated through independent benchmarking on the basis of the company’s historical performance over multiple years and any industry trends. In case there is a real shift in the economic structure of the company due to some events, the reasoning behind the different treatment of the events compared to the historical performance needs to be explained.

Comparable Companies and Market Multiples

It is possible for the Market Approach to produce another type of cognitive bias which involves herding. Herding occurs when valuers and analysts tend to use certain comparables as well as EBITDA multiples which are frequently used in the market, but do not necessarily apply to the target firm being valued.

A company valued at 10x EBITDA does not necessarily mean that another company is to be valued at 10x. There are many factors that might differentiate the companies, such as size, growth, profitability, capital structure, liquidity, geographical diversification, customers’ base, management, and risks, which would warrant different valuation multiples for the two companies. Thus, a valuer has not only to ask the question “what multiple is the market using?” but also “why is this company entitled to this multiple?”

The issue is likely to be even more pertinent in the case of the Egyptian market, where the availability of adequate listed companies as comparables as well as transaction data for certain sectors, business models, and private firms may be inadequate. Inadequate local data may mean that greater use of international comparables and transactions as well as subjective judgment may need to be made in the process of the valuation. This does not, however, imply any loss of validity of the valuation exercise, but increases the need for proper documentation of the choice of comparables as well as the rationale behind exclusion of certain firms.

Independent benchmarking could also offer another level of protection from herding. The valuer needs to determine if the chosen comparables are truly relevant, as opposed to popular among other market participants. If international comparables have been employed because of insufficient data in the Egyptian market, then the distinctions between the reference market and the Egyptian company need to be factored into consideration. The Market Approach must also be validated through either the DCF or Asset Approach wherever necessary. The idea is not to artificially ensure that all valuation approaches produce similar results, but to examine any disparities and figure out whether they have a sound economic basis.

Overconfidence and False Precision

The use of financial models gives the illusion of accuracy more than what is supported by the underlying assumptions. For instance, the DCF approach may result in the conclusion of equity value of EGP 3.25 billion, although this does not imply that the true value of the business can be calculated accurately to within EGP 10 million. This is an example of overconfidence bias.

This becomes highly relevant in case where a significant share of the enterprise’s value arises from its terminal value. Slight variations in WACC and terminal growth may result in drastic variations in value of the company. Sensitivity analysis, scenario analysis, and valuation range thus offer a better reflection of the uncertainty involved. The objective here is not to undermine the valuation conclusion but rather show what drives the value of the firm.

It is important to understand that valuation uncertainty is different from cognitive biases. Reasonable valuation results range alone does not indicate poor quality of valuation process. Valuation is an uncertain task by nature since there is no way to predict with absolute certainty cash flows, market environment, cost of money, economic cycles, and many other aspects of valuation. The problem is that cognitive biases can have an effect on the range of reasonable valuation results.

In this respect, providing a range of valuations or highlighting the sensitivity of the conclusion to certain assumptions cannot be viewed as a sign of weak confidence in the valuations performed. On the contrary, the transparency of uncertainty will mean that the valuer understands the weaknesses in the existing information and has taken into account the aspects that may affect the value of the asset. It is not the task of the professional to provide a false sense of certainty; it is to provide an appropriate conclusion based on the existing evidence.

Professional Skepticism

The valuation of the company is not just an endeavor to convert management’s business plans into numbers within the financial model. While the management may be the best person to get the information on the company, he may also have an incentive to make a very rosy picture of the future. It is incumbent upon the valuer to scrutinize management’s assumptions.

The same principle holds for information provided by shareholders, transaction advisors, market participants, or prior valuation reports. Is it reasonable to assume that the margins can be achieved? Is growth in line with the market’s capacity? Are the comparables used truly comparable? Have the risks been properly assessed? Has any risk been double-counted? Professional skepticism is not about being conservative or negative; rather, it is making sure that the assumptions that go into the value of the company are based on evidence and consistent.

Professional skepticism must be incorporated into the larger valuation governance framework rather than be a personal and informal process. Relevant valuation assumptions must be tested, especially those that significantly affect the outcome of the process. The basis for selecting similar firms and transactions needs to be recorded, including those for excluding any other related information. Historical forecasts made by management should also be compared against the actual outcomes to determine whether they are reliable and how any inconsistencies can affect future assumptions.

Appropriate checks should also be included as part of valuation governance for the same conclusion derived from different valuation methods wherever possible. For instance, any large difference between the DCF method of valuation and that of Market Approach must not be brushed off and instead be investigated. Again, sensitivity and scenario analysis need to be carried out to ascertain whether the conclusion is still valid under different assumptions. In case of significant valuations, the process can be challenged by getting an independent valuation done on the same.

A Practical Approach to Mitigating Cognitive Bias

Management of cognitive biases needs to be incorporated into the valuation procedure itself, and not seen as an issue of personal understanding alone. The process of management needs to start off with the independent assessment of the financial and business data from the past, prior to any other type of information being taken into account, like the target price set by management itself.

Key assumptions must be documented along with evidence in support of them. The evidence in favor of important revenue growth assumptions, margins, capital expenditures, working capital, terminal growth, discount rates, and valuation multiples must be provided. If any evidence is contrary to the chosen assumption, then it should not be overlooked; rather, it should be taken into account.

Forecast versus actuals analysis of history should be done in order to measure the reliability of management forecasts. This is especially necessary when there are considerable differences between the past performance and the forecast made by management. It may also be possible to challenge the forecast by independent benchmarking against industry growth, operating capacity, market conditions, inflation, foreign exchange, and others.

Sensitivity and scenario analysis should be utilized to determine the most influential factors in regard to value. The analysis should not be done solely based on one point estimate but rather if the conclusion is still valid if other factors are used in its calculations.

The fourth step is that independent review must be included when applicable. The independent reviewer will challenge the methodology, assumptions, comparables, normalization factors, discount rate, terminal assumptions, and conclusion. This does not mean that the valuer is being absolved of his or her responsibilities, but simply that another control is in place to catch any unsupported assumptions or cognitive biases.

The Egyptian Market

The concept of cognitive bias becomes highly relevant to Egypt for the following reason: the valuation of companies depends on considerable amounts of professional expertise with regard to issues like inflation, foreign exchange, interest rates, country risks, and available comparable market data. Indeed, high nominal revenue growth amid inflation does not guarantee that real revenue growth will be similarly high, and significant changes in currency will influence both foreign-currency income and costs.

Availability of local comparables and transaction evidence may also be constrained, especially in cases where the valuation concerns private enterprises or specialized industries with unique business operations models. In instances where local evidence from Egypt is limited, valuers may have no option but to use international comparables and transaction evidence along with professional judgement and qualitative adjustment to value the enterprise. This makes it important to document the reasons for the selection and adjustment of the market evidence.

Also, the lack of comparative transactions or comparable companies might result in increased potential for anchoring and herding. Due to the existence of few transactions or comparables, there will be an increased tendency to attach too much weight to the one transaction multiple or comparable company valuation that exists. In such a case, the valuer needs to weigh the merits of the available information in terms of its quality, relevance, and timeliness instead of just using market information since it is easily available.

This is also true for privately held or family-owned businesses in which there may be considerable variance in the quality of historical accounting, management information, governance, and business plan development. In such situations, the accuracy of the valuation process relies largely on the capacity of the valuer to normalize historical performance, independent verification of management projections, selection of comparable local and international businesses, and consistency of the cash flow projections with the discount rate. In a volatile environment, overcoming cognitive bias forms part of valuation judgment.

Conclusion

Cognitive bias may impact company valuation at almost every step ranging from initial assessment of the firm, to forecasting by the management, to selection of comparable companies and concluding with the discounting cash flow approach and/or market approach valuation. The biases which need to be known to valuation professionals are anchoring and confirmation bias, optimism and conservatism, recency and availability bias, market multiple herding, overconfidence, and professional skepticism.

The answer is not to do away with judgment altogether, since judgment is a necessary element of business valuation. Rather, the goal is to control the judgment by a process that is based on facts, benchmarks, assumptions, forecast vs actuals historically, testing of management forecasts, independent choice of comparables, scenario and sensitivity analysis, and proper review.

Management of cognitive biases should hence be part of the valuation process itself rather than being a matter of professional individual awareness. There needs to be a proper valuation governance structure where there is testing of the important assumptions made and their documentation, testing of management’s forecasts against past performance, selection and adjustment of comparables and transactions based on reasonable explanations, and where the results can be validated by other valuation approaches and scenarios.

However, valuation uncertainty must be reported transparently without confusing it with cognitive bias. A reasonable range of valuation outcomes is a result of uncertainty about future performance and the economic environment, and it should not in itself constitute evidence of low-quality valuation. It is more critical that there is judgmental influence that is either unjustified or biased affecting where in the reasonable range the conclusion falls. The important thing is for the valuation not to create a false impression of certainty but to provide justification for the conclusion drawn.

This issue is especially important in Egypt, where factors such as inflation, foreign exchange rate movements, interest rates, country risk, and lack of local comparables/transactions raise the need for professional judgment. However, this does not undermine the validity of valuation in any way; on the contrary, it makes the need for professional judgment more critical.

In the end, the validity of an organization’s valuation is not only about whether the financial model is accurate. It is all about the soundness, objectivity, and discipline of the judgment process that was used in the valuation process. In other words, a valid and defensible valuation would be where the assumptions are evidence-based, management forecasts have been questioned rigorously, comparables have been judged properly, independent judgment has been sought for key judgments, uncertainty is acknowledged openly, and finally, where the final judgment can stand up to professional scrutiny even if reasonable valuations lie in a range.

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