2 Philosophical Considerations for a Business Valuation

Business Valuation is not a commodity service; it is both an art and a science. There are multiple factors that must be considered to ensure the proper crafting of a robust valuation. For anyone seeking a business valuation, selecting an experienced analyst who understands these factors and more importantly how to navigate their implications is of paramount importance.

Let us highlight just two factors for reflection:

  • Bias
  • Uncertainty

These challenges must be addressed from the beginning to ensure the valuation remains robust. Why? Let see firsthand how these challenges can have a significant impact:

Bias in the valuation process can doom an otherwise good valuation. The well-known anchoring effect from psychology highlights this factor well:

In this experiment, business students were asked if they would pay the last 2 digits of their social security numbers for each of several items (e.g., 34 = $34).

Next, each bid the maximum amount they would be willing to pay for each item.

Did the initial “anchor” amount influence each student’s ultimate bids?

Although students were reminded that the social security number is a random quantity conveying no information, those who happened to have high social security numbers were willing to pay much more for the products.?

Source: Dan Ariely's Predictably Irrational
Source: Dan Ariely?s Predictably Irrational

Effectively, the human mind anchors its conclusions to initial information even if that information is completely useless.

In regards to valuations, an unguarded analyst might let the initial ?value? of the firm provided by a well-intentioned client anchor his/herultimate valuation conclusion at the detriment of objectivity.

The well-rounded analyst, aware of this effect, can be better prepared at preserving the objectivity of the valuation. Naturally, this approach means the analyst will likely choose a framework that requires more objective data and fewer conclusions taken at face value. A natural consequence of this change means a slower and more methodical process is performed.

Uncertainty constitutes another factor that is unavoidable in any valuation. Uncertainty is a perpetually present force that exists on a spectrum. On one extreme is the uncertainty of the cash flows associated with US Treasury Bonds, which is virtually nonexistent and thus why the investment return for it is so low (only 1.7% for a 10 year as of this writing). On the other extreme is the uncertainty of the cash flows associated with a pre-revenue startup in the “ideating” phase i.e. we have a great idea.

While the principles of valuation always apply ($1 today is worth more than a $1 tomorrow) the methodologies (discounted cash flow, market multiples, asset replacement, etc.) vary from situation to situation. A well-rounded valuation analyst has the informed judgment to know when to apply the right tools (from a large toolkit) for the job.

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