Generalities about Valuation

Like all analytical disciplines, valuation has developed its own set of myths over time. This section examines and debunks some of these myths.

Myth 1: Since valuation models are quantitative, valuation is objective

Valuation is neither the science that some of its proponents make it out to be nor the objective search for the true value that idealists would like it to become. The models that we use in valuation may be quantitative, but the inputs leave plenty of room for subjective judgments. Thus, the final value that we obtain from these models is colored by the bias that we bring into the process. In fact, in many valuations, the price gets set first and the valuation follows.

The obvious solution is to eliminate all bias before starting on a valuation, but this is easier said than done. Given the exposure we have to external information, analyses and opinions about a firm, it is unlikely that we embark on most valuations without some bias. There are two ways of reducing the bias in the process. The first is to avoid taking strong public positions on the value of a firm before the valuation is complete. In far too many cases, the decision on whether a firm is under or over valued precedes the actual valuation1, leading to seriously biased analyses. The second is to minimize the stake we have in whether the firm is under or over valued, prior to the valuation.

Institutional concerns also play a role in determining the extent of bias in valuation. For instance, it is an acknowledged fact that equity research analysts are more likely to issue buy rather than sell recommendations,2 i.e., that they are more likely to find firms to be undervalued than overvalued. This can be traced partly to the difficulties they face in obtaining access and collecting information on firms that they have issued sell recommendations and to the pressure that they face from portfolio managers, some of whom might have large positions in the stock. In recent years, this trend has been exacerbated by the pressure on equity research analysts to deliver investment banking business.

When using a valuation done by a third party, the biases of the analyst(s) doing the valuation should be considered before decisions are made on its basis. For instance, a self-valuation done by a target firm in a takeover is likely to be positively biased. While this does not make the valuation worthless, it suggests that the analysis should be viewed with skepticism.

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