Aswath Damordoran, Professor of Finance at the Stern School of Business at New York University, makes some interesting comments about the nature of valuation in his recent blog. It is refreshing to see an eminent academic slaying some of the myths that I have consistently encountered when valuation is discussed, both with those outside of the valuation profession and, alas, with too many within it. Common to all of these is the tendency to emphasise process over result.
My own valuation training was mainly by distance learning alongside working as a trainee in a valuation firm. As a consequence, I could see right from the beginning of my career that while my academic study provided tools essential for the job, these tools rarely, if ever, gave you the answer in practice without some metaphysical input, or what my old boss used to refer to as “gut instinct”. The impact on the valuation calculation of the different theories on how to adjust for tax on accumulations in a sinking fund was not something that figured highly when telling a client what you thought his property was worth!
Professor Damordoran identifies knowledge of accounting, modelling and finance theory as useful tools for the valuer but goes on to put these in their place by saying that his valuation course is NOT about these things. He brings up the traditional conundrum of whether valuation is an art or science and posits that it is neither. His conclusion that it is a craft analogous to cooking or carpentry is interesting but I would argue that this is only right up to a point. Certainly the mechanics of valuation can be termed a craft but the majority of valuations commissioned in practice are intended to be relied upon by the recipient, or a related third party, to support investment decisions. This also means that the valuer must also be operating under an ethical framework to ensure that the valuation process is not only free from bias but is also seen to be free from bias. For a valuation to be useful it must be capable of being relied upon, and to be relied upon, recipients must have confidence in it. No matter how well-crafted the valuation, unless it is provided by a valuer operating to proper professional standards others are unlikely to have confidence in it.
Returning to my central theme, in my experience effective valuation depends on the valuer not only possessing the analytical skills that come from the ability to navigate financial statements and understand basic statistical and financial theory but also the ability to understand the relevant market. This is not simply knowledge of and the ability to analyse price data. That is something any old algorithm can do. Price data is, by definition, historic. Any current valuation needs also to reflect trends and expectations at the valuation date. And if the valuation is required to reflect the price in a market transaction, which is the benchmark required for many purposes such as “fair value” in financial reporting, then understanding the mind set of market participants on the valuation date can be as equally important as analysis of previous transactions. Indeed, when any market suffers a period of illiquidity the absence of deals means that good valuation needs understanding of the level at which buyers and sellers would enter the market.
A related issue is that the study of any market will show that buyers and sellers do not always act rationally. The emerging theories around “behavioural finance” attempt to use cognitive psychology to develop theories that explain and increase understanding of the irrationality of market participants, but these are not without critics. They also focus on identifying matters that influence apparently irrational behaviour with few suggesting it can be measured empirically. However, while a valuer may not be realistically expected to anticipate or measure irrationality, a good one will be aware of it when analysing data and deciding its relevance in arriving at their conclusion. And the only way that a valuer can really understand market sentiment and whether this is rational or irrational is by having deep knowledge of a market developed over time. Indeed, I have often argued before a valuer is let loose on the public they should have had an extended period of negotiating deals in the relevant market. Direct involvement with actual market participants gives insight into their behaviour under different circumstances which can be invaluable in valuation scenarios where one is required to understand how hypothetical market participants would behave.
So in conclusion I suggest that where the exercise of the craft of valuation is to produce figures that others will rely on it is, or should be, regarded as a profession. But if valuation is neither art nor science, is it perhaps a collision between mathematics and psychology?