Creating More Accurate Acquisition Valuations

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.

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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.



1. See A. Tversky and D. Kahneman, “The Framing of Decisions and the Psychology of Choice,” Science 211, no. 4481 (January 1981): 453-458. For an overview of psychology in finance, see, for instance, N. Barberis and R. Thaler, “A Survey of Behavioral Finance,” in “Handbook of the Economics of Finance,” ed. G.M. Constantinides, M. Harris and R.M. Stulz (Amsterdam: Elsevier, 2003), 1052-1114; and M. Baker, R. Ruback and J. Wurgler, “Behavioral Corporate Finance: A Survey,” in “The Handbook of Corporate Finance: Empirical Corporate Finance,” ed. B.E. Eckbo (New York: Elsevier, 2004), 351-417. For a discussion of the impact of biases on practical acquisition decision making, see, for instance, D. Kahneman and D. Lovallo, “Timid Choices and Bold Forecasts: A Cognitive Perspective on Risk Taking,” Management Science 39, no.1 (January 1993): 17-31.

2. This resembles the disposition effect. See H. Shefrin and M. Statman, “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence,” Journal of Finance 40, no. 3 (July 1985): 777-790; and I.M. Duhaime and C.R. Schwenk, “Conjectures on Cognitive Simplification in Acquisition and Divestment Decision Making,” Academy of Management Review 10, no. 2 (April 1985): 287-295.

3. Executives tend to know if deal markets are hot or cold, and that is much easier to assess than their own biases. In times of financial market exuberance, frenzied behavior by acquirers and executive focus on value, a high number of acquisitions should indicate a “hot” deal market. In times of financial market pessimism, passive investor behavior and executive focus on risk, a low number of acquisitions should indicate a “cold” deal market.

4. See R.J. Shiller, “Irrational Exuberance” (Princeton, New Jersey: Princeton University Press, 2000).

5. Experimental evidence shows that people who are offered a new gamble tend to evaluate it in isolation from other risks. For instance, see N. Barberis and M. Huang, “The Loss Aversion/Narrow Framing Approach to the Stock Market Pricing and Participation Puzzles,” in “Handbook of the Equity Risk Premium,” ed. R. Mehra (Amsterdam: Elsevier, 2008).

6. For further reading on real options, see A.K. Dixit and R.S. Pindyck, “Investment Under Uncertainty” (Princeton, New Jersey: Princeton University Press, 1994); H.T.J. Smit and L. Trigeorgis, “Strategic Investment: Real Options and Games” (Princeton, New Jersey: Princeton University Press, 2004); and L. Trigeorgis, “Real Options: Managerial Flexibility and Strategy in Resource Allocation” (Cambridge, Massachusetts: MIT Press, 1996).

7. This option is exercised (with the bid being equivalent to the exercise price) only if positive economic developments increase the payoff from the full acquisition. Like all call options, the greater the uncertainty, the greater the potential upside (profit) potential, whereas the downside risk is limited to the premium of the option.

8. In such cases, the acquisition forms the underpinning factor that provides the optionality to proceed to the next stage, if and when it becomes beneficial to do so. Such an investment can have high growth option value when it involves an option on options, or a compound call option. Following this approach, new growth options and uncertainty can actually move investment forward.

9. In addition to call real options — for example, to defer, stage or grow — put real options also exist to divest part of the company early. When restructuring a company, an investor may consider company assets as a portfolio of put options. When the present value of the remaining cash flows of part of a business falls below the resale value to a potential buyer, the asset may be sold — effectively exercising the owner’s put option.

10. For instance, EBITA (Earnings Before Interest, Taxes and Amortization) is a measure for operating profitability that uses accounting data that corrects for the financing structure of the company. A related measure, EBITDA, also corrects for depreciation.

11. This is similar to a call option on the value of synergistic benefits, where the exercise price is the cost of the merger.

i. See H.T.J. Smit and T. Moraitis, “Playing at Acquisitions: Behavioral Option Games” (Princeton, New Jersey: Princeton University Press, in press).

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