I must confess that I was a skeptic on behavioral financing until a few years ago. At that point, the quantity of information that was gathered on the “irrational” behavior of traders became so overpowering that I confronted 1 of 2 choices. Reconciling behavioral finance with my view of the world has been tougher in my own other market: valuation. Every semester that I educate the valuation course, using the tools of the trade (reduced cashflow models, comparative valuation), I am asked how I’d incorporate the results from behavioral finance into valuation. Here is my reaction.
I don’t believe intrinsic valuation techniques changes much, if, as a total consequence of behavioral economics. The expected cash flows remain the expected cash flows and the mandatory return still have to reflect the perceived risk in the investment. So, what does change? Remember that to generate income of your valuations, not only must you be able to value assets however the price has to move towards that value. Why do different analysts reach different estimates of value for the same company? When you value an ongoing company, you are among the many doing so, drawing on a single information as other investors often, and using the same models often.
So why do different analysts reach different estimates of value? How come the price differs from the value? In the classical world, the purchase price can deviate from value because investors make errors or because the purchase price may reflect information that the analyst … Read more