Business valuation: In defense of simplicity
By Erik Kobayashi-Solomon, Principal and Founder, IOI Investor Services
Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.
Which is more likely true about Linda?
A) Linda works as a bank teller
B) Linda works as a bank teller and is active in the feminist movement
Eighty-five percent of respondents to this question answered incorrectly – that B) is more likely. (To find out why B) is incorrect, see the excellent explanation here.)
The fact that such a large percentage of intelligent, well-trained respondents answer this question incorrectly reveals an important insight into the way we as human decision-makers process information. Namely, that we as human decision makers actually utilize two pathways to process information – one of these is capable of complex reasoning while the other is reflexive and primitive.
During most of human history, we have had to use the methodical, complex mental pathway only rarely, and have instead leaned on the reflexive, primitive pathway. It’s only natural that solving problems using the primitive pathway feels more comfortable to us. We use it to manage our daily lives – recognizing people and common situations by finding patterns in everyday occurrences.
This primitive pathway is the one that 85 percent of respondents use to answer the question about Linda.
While this primitive mental pathway feels more comfortable to us, it is actually ill-suited to many tasks necessary in a modern information economy, including (and especially) those related to valuing companies and investing in them.
All of us in the business of valuation have a sense that we want as objective of a yardstick as possible when valuing firms – in order to minimize errors and improve accuracy. While it is, in some sense, uncomfortable for us to do so, we attempt to set aside our primitive mental pathway and dig into analyzing the economics of a business using our complex reasoning pathway. The more we dig in, the more we find the minutiae strangely comforting. We keep diving deeper and deeper into our spreadsheet until it is 30 tabs long and contains every shred of obscure, barely-relevant data available.
And while we may think that going to these lengths improves the quality of our valuation, in truth, the opposite is true. We become overwhelmed by all the data, unsure of which is the most important piece, and probably making a calculation error or two along the way.
It seems like a no-win situation. If we use our primitive mental pathway, we feel happy and confident but are often wrong. If we use our methodical, complex mental pathway, we end up getting bogged down and confused.
The way around this conundrum can be expressed in a single word: Simplicity.
A good analysis is a simple analysis – focused on only a few key drivers. And while it is best to make our models “as simple as possible but no simpler” (to paraphrase Albert Einstein) it is important that we are using our complex reasoning mental pathway as the cornerstone of the process.
Join Sageworks’ complimentary webinar, “Avoiding Bad Decisions in Business Valuation: Pitfalls and Solutions,” featuring Kobayashi-Solomon on Tuesday, May 3, from 2 to 2:30 p.m. ET.
Erik Kobayashi-Solomon has held prominent roles in operational risk control at Morgan Stanley Japan and market risk management for several hedge funds. He is the author of the 2014 book The Intelligent Option Investor, a regular contributor to Forbes and instructor of small-group valuation and option investment training classes around the country. In the course of his nearly 20-year career, Erik has been the architect of models at the heart of hedge fund strategies and those used by influential institutions to value public and private companies across the globe.
Post image credit: Modified from “Simplicity,” by Jase Curtis via Flickr CC