Lecture 2: Ch. 3 & 4

Question 1

What are five practical valuation heuristics used by companies?
Why financial executives rely on these heuristics so much?
What behavioral phenomenon can be used to explain that?

Answer 1

• Price/Earnings ratio
• P/E heuristic (comparable firm or industry average, proxy)
• PEG heuristic (adjusted for growth, as EPS is influenced by expected growth)
• Stock valuation rule (P=PEGxEPSxg)
• Price-to-Sales Heuristic
  In this context ‘Heuristics’ has a general meaning of Common Practical Rules of thumb (not to be confused with psychological heuristics!)

Many financial executives/analysts rely on heuristics instead of the fundamental valuation techniques [from] textbooks, because it is easy to understand - people like simple things (comparing to the complicated excel model with DCF method).

P/E, PEG, Price-to-Sales are simple and have intuitive appeal, analysts feel comfortable applying them -> this is related to affect heuristic

Question 2

What behavioral phenomena can be seen in company valuations? How and where exactly?

Answer 2

› Affect Heuristic: simple intuitive rules such as P/E, PEG and Price-to-Sales ratio [in view of the complexities & uncertainties of the DCF approach]
› Bounded Rationality (due to limited information,
complexity & uncertainty): Reliance on simplified Frames and on Heuristics [Such as averaging by 1/n]
› Over-Optimism: when forecasting earnings, cash flows and growth:
› Naive Trend Extrapolation, based on Representativeness Heuristic: implicitly perceiving growth opportunities by focusing on short-term EPS growth: pattern recognition → extrapolation.
Anchoring may drive too much reliance on past growth too.
› Impact of Agency issues: incentive to make favorable reports

Question 3

What is planning fallacy? What it is driven by and what are the two root causes for it?

Answer 3

[Large, Compex] Projects typically tend to disappoint. Specifically:
− Costs, risks and completion times are underestimated
− Expected revenues are overestimated (e.g. for railways - tickets sold/passengers)

Planning Fallacy is driven by Delusional Optimism.

Question 4

What are behavioral explanations for avoiding project terminations?

Answer 4

› Prospect Theory
- Risk Attitude in Domain of Losses = Risk Preference
- Decision Weights: Overstatement of Small probabilities)
› Mental Accounting & Loss Aversion
- People hate to close an account with a loss
- Driver of so-called Sunk-Cost Fallacy (people don’t forget sunk costs)
› Emotions
- Specifically, feelings of regret
- Augmented by feeling responsible
› Role of Limited Self Control
• disposition to procrastinate painful decisions
› Social Norms
• Consistent behavior is more socially desirable (changing your strategy and decisions all the time is not considered to be good)
› Shefrin [2007] further adds:
• Aversion to a Sure Loss (“Breaking Even is the key issue”)
• Escalation of Commitment (feeling responsible has more impact when project decision has visibility)
• Confirmation Bias (ignoring/downplaying unfavorable information)

Question 5

What are the psychological causes of planning fallacy?

Answer 5

A. Pychology
• Overconfidence amplified by biased self-attribution [drives underestimating the role of luck] and illusion of control
• Competitor Neglect: Executives tend to focus on own company’s plans and capabilities. [CEO: “you do not think that everybody is thinking the same”] → This relates to Narrow Framing
• Anchoring
• Adjustment from initial plan estimates [that have been designed to get the project approved] is typically insufficient.
• Shefrin [2007] adds: familiarity, representativeness, wishful thinking, and conjunction fallacy

Question 6

What are the organizational causes of planning fallacy?

Answer 6

B. Organizational [or Political] Pressures
• Internal competition for [constrained] resources may lead to ‘rational’ overoptimism.
- Biased forecasts: accentuate the positive to get project approved [→ strategic misrepresentation].
- Selection effect: funds are allocated to the most promising [excessively [?] optimistic] proposals [that thus have the highest chance of disappointment]
• Behavioral force from social interaction
- Ambitious goal setting is a tool for motivation
- Pessimism = disloyalty