It’s no secret that our coverage of Professor Aswath Damodaran’s well-attended session at last November’s AICPA/ASA conference in Las Vegas elicited passionate response from BV experts. During the course of his address, Damodaran said, “Appraisers often have a value in mind before they start the process and try to back into it.” Given the level of discussion, it only seemed fair to ask the esteemed professor to elaborate on and clarify his statement. Damodaran’s unedited response:
“I was guilty of both hyperbole and overstatement and I apologize. What I was trying to say—and said badly—is that we spend a lot of time in classroom, conferences, and books talking about valuation techniques, tools, and models and too little time talking about processes. However, flawed processes lead not only to flawed valuations, but also to the abandonment of first principles and common sense along the way. Let me offer three examples:
- Sell-side equity research. In 25 years of teaching, hundreds of my students have become equity research analysts and most understand valuation fundamentals very well. They go to work, are told to value the companies in their sector, and to prepare buy and sell recommendations on those companies. However, the very first sell recommendations that they turn out creates a backlash. The company shuts them out of future analyst meetings, portfolio managers within their own firm berate them, and investment bankers who hoped to get business with the company beat them up. Little wonder that even at the start of this bear market last year, buy recommendations outnumbered sell recommendations 8 to 1.
- The legal process. It is true: I have grown cynical with legal valuations. The court system, when faced with dueling expert witnesses, seems more often than not to want to split the difference rather than go with the witness who is more credible. Hence, if one expert witness is unbiased and the other is not, the system rewards the latter by taking the average. (One fix may be for the court to appoint a single expert witness to provide advice to the court, rather than to the two sides. Still, I do not know whether that is a practical solution.)
- The regulatory process. A few years ago, I was invited to talk to people involved in the utility regulatory process. As you well know, public utilities can set prices for their products based on earning a reasonable rate of return, which then leaves open the question of what a reasonable rate of return is. The audience contained analysts who worked for the utilities and analysts who worked for the regulatory authorities. I surveyed the two groups about the “right equity risk premium” before I started. What I found is that the analysts who worked for the utilities came up with 7% as the appropriate number, whereas the regulatory agency analysts felt that 5% would be more reasonable. Each group backed up their number with studies, statistics, and experts. However, the die was cast when they chose a side.
“Bad processes that feed into the bias (as these do) subvert the best intentions of appraisers. I do not believe that appraisers and analysts start with the intent of skewing the numbers, but bias is insidious and it will find its way into value. Thus, the appraiser working for the IRS in an estate-tax valuation will find a way to justify a lower illiquidity discount than the appraiser working for the taxpayer, and both sides will believe that they are justified.
“Admittedly, I have the luxury of speaking about this in the abstract; I am not dependent upon doing valuations for a living. Indeed, tenure is a luxury that most people do not have. However, as someone who truly and passionately believes in valuation as a science—and holds the utmost respect for BV professionals—I will continue to speak out against flawed processes and practices.”
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