In “hot” deal markets, executives often overvalue companies they are considering acquiring — and conversely undervalue potential acquisition targets when the economy is weak. Fortunately, there are steps managers can take to adjust deal valuations for these common biases.
Managers often must make decisions about complex strategic issues, and they are expected to make choices carefully and objectively. A private equity fund manager, for example, may have to decide whether to bid more in a highly competitive auction. A retailer may want to figure out whether to make an acquisition at a time when prices are at or near the top of the cycle. In a different vein, an auto company may want to determine how long to hold onto a money-losing plant as the economy sinks into a recession. Such examples speak to an interesting dilemma: In boom times, deals are often in demand and expensive (and acquirers tend to know it), but when the economy cools off, acquisitions fall out of favor and prices decline.
The psychology of judgment and decision making predicts that the way executives frame their deals partly determines their acquisition choices under uncertainty.1 On the one hand, investor exuberance, the positive sentiments of boards and the willingness of rival managers to invest at higher levels can cause executives in “hot” deal markets to view acquisition opportunities as more attractive than they actually are. On the other hand, cognitive biases — such as loss aversion and a narrow perspective that does not consider long-term growth options — subdue companies’ acquisition behavior during “cold” markets.2
A biased valuation analysis is worse than useless, so this article is designed to improve the use of valuation methods in a way that can help mitigate decision biases. (See “About the Research.”) Because it is difficult for executives to recognize their biases and make adjustments, we suggest they do something that should be much easier: Use a formalized process to de-bias the decision-making team. The initial step is determining whether you are facing an investment in a “hot” or “cold” deal market, something that can be revealed by the number of deals.3 Subsequently, we propose taking a broader view, supported by sanity checklists for predictable valuation biases and illustrated with cases.