Creating More Accurate Acquisition Valuations

Managers often must make decisions about complex strategic issues, and they are expected to make choices carefully and objectively. A retailer, for example, may need to decide whether to bid more in a highly competitive auction. Or a manufacturer may want to determine how long to hold onto a money-losing plant as the economy sinks into a recession. 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. Conventional capital budgeting methods for valuing acquisitions and investments (such as discounted cash flow) may result in overpricing in “hot” deal markets and underpricing in “cold” deal markets. By setting potential deals in the context of real options theory and behavioral economics, authors Han Smit and Dan Lovallo write, executives can compensate for potential biases.
Investor exuberance, the positive sentiments of boards and interest by rivals can cause executives to view acquisition opportunities as more attractive than they actually are in “hot” deal markets. Loss aversion and a narrow perspective that does not consider long-term growth options, meanwhile, can subdue acquisition behavior during “cold” markets.
The article is designed to improve the use of valuation methods and help mitigate decision biases. Treating acquisition decisions as simple go/no-go choices based on expected cash flows, the authorswrite, creates an unhealthy dynamic. Because it’s difficult for executives to recognize their own biases, the authors suggest using a formalized process to de-bias the decision-making team. First, managers must determine whether they are facing an investment in a “hot” or “cold” deal market (something that can often be revealed by the number of deals), after which the authors propose taking a broader view, supported by checklists. A valuation checklist can help executives temper their natural inclination to focus on growth options in “hot” markets and refocus it on staging, deferring or recouping their investments. Similarly, a checklist can help executives divert their natural attention from short-term risk to long-term growth options in “cold” deal markets.