Tuesday, March 31, 2015

Relative valuation & why anchoring is dangerous

One of the big problems I was having earlier was that I was rejecting a company with similar economics at a valuation of 10 times earnings and thinking of buying another company with similar economics at 15 times earnings. It took a while before I realized what was happening. The problem does not lie in valuation methodology as much as it does in psychology. Robert Cialdini in his book about the psychology of influence talks about real estate dealers who have a couple of houses listed at an exorbitant price which are in horrible state. These are shown to buyers before showing them the actual house they want to sell. It drives people to say yes to the actual house because relatively it looks like better value.

There are umpteen examples of where humans change their decision about what they are experiencing based on relative valuation rather than absolute. Tom Hopkins, one of the best sales trainer’s in the world, says that during the sales process you should always provide two options. One that is significantly worse than the other. It increases the chances of the buyer picking the better option – significantly more than just presenting the better option in the absence of the worse one.

This is exactly what my problem was. If saw a company (call it A) that I thought could grow at 5% per year for 10 years with a return on capital of 20% trading at 40 times earnings, I would find another one (call it B) that could grow at 10% per year for 10 years with a similar return on capital cheap at 20 times earnings. But if I saw a company (call it C) growing at 12% per year at 20 times earnings with the same economics before company B, I might not find company B cheap anymore at 20 times earnings. It is completely irrational but is the main problem with anchoring!