Unfortunately, bias is in every single valuation you do. Avoiding it is possibly the hardest part of valuing a business, because often you don’t even realize it’s there, and even if you do the preconceptions may still show up in your growth estimates for the future of the company.

The dean of valuation, Aswath Damodaran, has recently stated bias is the biggest reason for bad valuations. He gave an example of how he has valued Microsoft every year since 1986, and every year he found it to be overvalued. He goes on to say if you were to have a look in his house, it would be clear why he continued to find it overvalued. You would see his MacBook Pro with an Apple display above it, to the right his iPhone, to the left his iPad, and in his ears his Apple AirPods. The first step to counter bias, is to first realize it’s there.

In this blog post I’m going to go over the 8 most common biases in valuation, and what you can do to try and help minimize the effect of them in your valuations.

What is Bias?

According to Oxford dictionary, bias can be described as “a prejudice in favor of or against one thing, person, or group compared with another, usually in a way considered to be unfair”.

In valuation, bias can start as soon as you pick a company to start valuing, without you even realizing. Maybe you have used a competing product your whole life, and thus look negatively at the company. Or perhaps you’ve always loved the product and think the future will be a bit brighter than it actually will.

Without further ado, let’s look at the 8 most common biases in valuation.

The 8 Most Common Biases in Valuation

 

1) Confirmation Bias

Confirmation bias is the tendency to seek information, or interpret information, in a way that confirms your current beliefs on the topic. You may also dismiss any new information that goes against your current belief.

As an example of confirmation bias in valuation, let’s assume it’s a Friday night in 2006/2007, as always, you go to Blockbuster, tour all the aisles, and rent 3 movies, watch them over the weekend, and return them before those pesky late fees kick in (remember those?!). Later that week you decide to value Blockbuster, since Blockbuster is always packed when you’re there, it must be a good investment! You choose to ignore the competition of Netflix, and the dropping revenue year after year, but instead use the positive operating income (for the first time in 4 years) as evidence that confirms your thesis it would be a good investment

In hindsight, you might be thinking people must have been blind to miss the threat of Netflix, but a lot of people did. And that brings us to our next bias.

2) Hindsight Bias

Hindsight bias is the tendency to think events were more predictable after they have already happened. This often happens with macro-economic events, as well as with individual securities. It’s easy to look back at events and think you would have done something different if you were there.

An example of hindsight bias in valuation would be the 2008 financial crisis. Many people looking back believe it could have been easily predictable, and they would have sold off investments before it happened. In reality there were very few people that saw it coming and avoided the crash.

3) Survivorship Bias

Survivorship bias is focusing on specific entities that did well, while ignoring the ones that failed.

An example of survivorship bias in valuation would be investing in penny stocks. If you’re on a Facebook group where people continue to talk about how much money they’ve made off some penny stock (stay tuned for our next bias), you may get the idea that penny stocks are a great investment, either not knowing, or choosing to ignore, the fact that most people investing in penny stocks fail to make any money.

4) Bandwagon Bias/Fear of Missing Out (FOMO)

The bandwagon bias and fear of missing out are similar, so I chose to put them together. They can best be described as believing something because a group of others believe it, and you not wanting to miss out on the opportunity. It can make you believe something is realistic, or achievable simply because others do, where you otherwise would have come up with a different conclusion.

Examples of bandwagon bias, or fear of missing out, can be found in many of the investing social media groups. In 2021 the GameStop (GME) talk took over. Looking at the company’s financials it was clear that the company was not doing good, and did not seem to have a bright future, but a few people noticed it was a candidate for a short squeeze. As more people jumped in, and more people pumped it in social groups, the bandwagon/FOMO effect took over. People with no investing experience saw how much money some people made and wanted a piece of it. Unfortunately, a lot of those people ended up losing a lot of money, because they missed the initial jump.

5) Information Bias

Information bias is the idea that more information is better. In the digital age information and data is abundant. Back when Warren Buffet started investing, he received annual reports in the mail, and had to decide based on that if it was undervalued or not (which he still does!). Now with the internet, there are numerous websites that contain all sorts of data, including basic financial statements, all different ratios, and in-depth calculators.

An example of information bias in valuation would be looking at our own website’s financials page. Look at how much data is on the key metrics page. We’ve tried to keep it to the most important/useful information, but it’s still more data than anyone needs to be successful. It’s important to find the data that makes sense for you and your valuation method and stick to it. There is no need to go over every single metric for every single company you want to value.

6) Anchoring Bias

Anchoring bias is putting too much emphasis on the first piece of information you receive (anchor point). Often any new information/data is then compared to your anchor point, rather than looking at it objectively.

An example of anchoring bias in valuation is comparing the price of a security. If you look at a stock like Tesla (TSLA) when it is at $380/share, then it drops to $215/share, you may assume that it is cheap or undervalued, without objectively looking at the $215 share price and deciding if it is undervalued based on actual fundamentals.

7) Optimism/Pessimism Bias

Optimism bias is the tendency to believe positive events are more likely to happen, due to your personal biases about a specific event/entity. Pessimism bias is the opposite of optimism bias, where you tend to believe negative events are more likely to happen.

An example of optimism/pessimism bias in valuation is how some people view the company Apple. Some people that are iPhone or Apple users in general may have an optimism bias towards the company, thinking things may be better than they will simply because they absolutely love the products. While someone with an Android phone may have a pessimism bias towards Apple because they hate the products.

8) Sunk Cost Fallacy

Sunk Cost Fallacy is an important bias to be aware of in valuation. It’s the tendency of someone to continue with a strategy/idea simply because they have invested a lot of time/money into it.

An example of sunk cost fallacy in valuation would be spending 2 weeks researching a company, reading all the 10Ks’, calculating an intrinsic value, just to find out it wasn’t quite as undervalued as you thought. With the sunk cost fallacy, you may decide to invest anyway, because you invested so much time into researching it.

Another example might be if you had invested in a company such as Alibaba (BABA). You may have underestimated the political risk but continue to hold because you are down so much, even if the risk is making you lose sleep (you should never invest in anything that makes you lose sleep).

What Can You Do About Bias in Valuation?

So now that you know bias can be the largest problem with your valuation, what can you do about it? I’ve come up with a few tips that I personally use to help myself keep aware of potential biases, that remind me to take a step back and look at things objectively.

  • Before starting your valuation, write down all your preconceived thoughts about the company, good or bad.
  • Come up with a list of rules for when to invest and stick to them. If you only want to invest in companies that are 50% of the intrinsic value you calculate for them, do that and don’t make exceptions because you spent so much time on the valuation.
  • If the price drops from when you start your valuation, take a step back and realize that there may be a reason. Double check your research, and make sure the new price reflects your required discount.
  • Take other people’s opinions online with a grain of salt. Do your own research and see if what they are saying makes sense. Look at it objectively and form your own opinion.
  • Don’t put too much emphasis on the past. Just because something was successful in the past doesn’t mean it will be successful in the future. Use realistic growth numbers, not your hopes and dreams.
  • If things fundamentally change, don’t be afraid to sell at a loss. One of my favourite quotes from Warren Buffett is “You don’t have to make it back the way you lost it.”.