Could Real Options Be the Solution for Over- and Undervaluation in Hot and Cold Deal Markets?

Key words: M&A, Biases, Debiasing, Real options, Experiment

Table of Contents

Introduction 3

Theoretical Framework 6

Valuation Methods 7

Cognitive Biases 9

Anchoring 9

Over-optimism/Overconfidence 11

Relation temperature of the market and overconfidence 17

Loss Aversion 19

Relationship temperature of the market and loss aversion 20

Narrow framing 22

Summary – Hypothetical relation between market temperature and valuations 24

Real options as a solution for static DCF valuations 28

Real options 31

Experiment 33

Conclusion 40

Appendix : Experiment 43

Bibliography 51

Introduction

How could one explain that CEOs of competing companies are queuing up to acquire the same targets when they know that prices are high, whilst the same CEOs shy away from comparable targets when prices are low? Does the underlying value of these targets really differ that much over different points in time, or is it possible that valuations are biased? If so, is this not paradoxical since CEOs are in that position because they are supposed to value potential investment opportunities objectively and independently? Research has shown that because of framing effects on the valuation of investment opportunities by executives, valuations indeed appear to be biased in different phases of the business and M&A cycle. Apparently executives tend to be optimistic about a target’s potential during upward fluctuations in the business cycle, which results in heavy competition for take-over targets with high prices and ultimately many deals being done. Inversely, executives seem to be reticent during downward fluctuations, which results in few deals being done whilst prices are relatively low. These market situations can be described as ‘hot’ and ‘cold’ deal markets (as proposed by Smit & Lovallo (2014)). One of the problems which may partially be a result of deals done in a hot deal market, is the vast amount of deals that later turn out to be failures, with substantial problems for society (Camerer & Lovallo, 1999) & (Financieel Dagblad, 2014). However, this is not the sole problem related to fluctuations in the amount of deals. When executives decide to acquire targets because of over-optimism, and this is done on a large scale, this might lead to a market which is excessively concentrated. The related consequences are widely known: less competition and potential lasting changes in the market structure. For society, competition leads to more efficient outcomes. A cold market also gives rise to various problems, the most predominant of which is forfeited economic value due to good deals going to waste.

Given the problems described above it is evident that solutions to this hot and cold deal market phenomena should be subject to research. Among others, Smit & Lovallo (2014) and Smit & Moraitis (2010) have treated this subject and provide a possible solution in the form of real options. By using the real options approach as an addition to conventional valuation methods, they see a way of correction for over- and undervaluation in respectively hot and cold deal market situations. As earlier mentioned, over- and undervaluation could be the result of executives’ over-optimism and overconfidence in a hot market situation and reticence in cold deal markets, which, in turn, may be the consequence of earlier experiences. When using the DCF method, the above is illustrated by executives’ potential exuberance of the horizon value in a hot deal market, as they focus too much on growth possibilities. In a cold deal market, executives focus too much on the risk of an investment and therefore the initial outlay, whilst little attention is paid to the horizon value. Combined with executives’ perceptions of the possible investment as a ‘Go-or-no-Go decision’, this results in a static valuation which could lead to biases in the valuation of this possible acquisition.

Smit & Moraitis (2010) distinguish various ways of how these biases could influence the valuation. Anchoring and overconfidence could be reasons for overvaluation in hot deal markets. In cold deal markets anchoring, narrow framing and loss aversion could explain why executives are reluctant to invest or undervalue targets. The experiment solely tests if potential differences in the valuation during hot and cold deal market settings are the result of overconfidence and a combination of narrow framing and loss aversion. More specific, the goal of the experiment is to test whether a difference in valuation following a divergent prior business experience occurs and whether the implementation of real options could provide a solution, which is manifested if participants are able to recognize the setting in which real options are embedded. The question which bias is the real cause of the potential difference in the valuation between executives in a hot and cold deal market, or which one outweighs the other potential bias, is therefore also relevant. In order to answer these questions, an important assumption has to be made: M&A market activity (in the rest of this paper also referred to as the temperature of the M&A market) is related to the state of the economy/business cycle (Becketti, 1986); (Harford, 2005); (Andrade & Stafford, 2004). Consequently, the possible event that executives’ valuations vary in different states of the M&A market, could be caused by prior business experiences which are associated to these different states of the M&A market. In short, a hot deal market is assumed to be accompanied by experiences of an economic upturn, whilst a cold deal market is assumed to be accompanied by experiences of an economic downturn. An additional assumption is that the aggregated economic conditions are positively correlated to a company’s prior business successes. This assumption is made, since the hypotheses of the experiment are based on personal-level biases.

The reasoning behind the solution for the influence of biases on the valuation process as proposed by Smit & Lovallo (2014) is basically as follows. The aforementioned over-optimism by executives in hot deal markets should be tempered by instilling caution via real options, which should offset the causes and amplifying factors of over-optimism, such as the ‘illusion of control’. The kind of real options that could prove valuable in this sense are the so called options to defer or stage investment. This basically means that executives should sometimes wait investing rather than perceiving an investment opportunity as ‘now or never’/’Go-or-no-Go’ and consequently be better off. By using a wait-and-see strategy the downside risk will be weakened. For the executives’ pessimism, inherent in cold deal markets, a sense of venturing has to be conveyed, once again via real options. The most important real options in this regards are the growth options, options to switch as well as abandonment options. These options are often present in investment opportunities, yet they are overlooked by executives because of a narrow frame. By increasing the awareness of executives that these options exist and are embedded in investment opportunities, the valuations of such projects should increase and the focus on risk reduce.

The statements made by Smit & Lovallo (2014) that in a hot deal market executives focus too much on growth, whilst in a cold deal market too much on risk, result in the conclusion that valuations of executives framed in a hot deal market should differ from valuations made by executives framed in a cold deal market if the valuated venture is the same. This paper offers a form to empirically test whether this conclusion is true and if real options could change this. The actual empirical test will be carried out in future research. The first step in this experiment is to test whether a difference in valuations occurs when participants are confronted with a hypothetical venture and framed in a situation of an economic up- or downturn in both the financial market and in their company’s performance. The valuation is based on the discounted cash flow method. The described venture should embed the possibility for participants to perceive growth options. Subsequently, in order to test if real options could be a solution for the potential difference, certain important characteristics inherent to real options will be made explicit. The kind of real options depends on the market setting in which the participants earlier have been framed. These questions provide the opportunity to see whether participants are able to recognize the use of real options and, since they should alter the valuation consequently. For both the group of participants framed in a hot deal market and the group of participants framed in a cold deal market, a control group is formed. The same questions are posed to these control groups. They only differ from the other participants in the way that they are not initially framed. In other words, are not presented with a prior business involvement.

The above leads to the following question:

Are executives able to recognize the existence of real options in order to alter their valuation of investment opportunities during a hot and cold deal market?

The structure of this paper is as follows. Firstly, the theoretical foundations of the experiment will be discussed. This will be done by a justification and explanation of the hypotheses. To begin with a short explanation of the application of the conventional valuation methods: DCF and multiples analysis. Secondly, the relevant cognitive biases will be described. Next, the hot and cold deal market phenomena will be treated, with emphasis on the causes of these occurrences, after which a clear delineation will be made as to which reasons will be considered in this paper. After this, a combination of the DCF, the relevant cognitive biases as well as the relevant reasons will be made, aiming to properly describe the problem and thereby making clear what possible solutions the composed experiment seeks for. Successive to this, the relevant real options will be described. Thereafter, the problem will be regarded in the light of these real options in order to explain how these options can theoretically provide a solution. In the line of this theoretical foundation, four hypotheses will be constructed, which will serve as propositions the experiment to be composed seeks to test. As the theoretical considerations underlying the experiment have been thoroughly explained, the experiment section of the paper will be concerned with a step-by-step explanation of the formulation and composition of the experiment. The conclusion of this paper will summarize the considerations underlying the composition of the experiment, as well as to give some suggestions and points of improvement that should be regarded when composing an experiment regarding this issue.

Theoretical Framework

As earlier mentioned, the goal of this research is to construct an experiment which tests whether there is a difference in the valuation of an equal investment opportunity as a consequence of the condition of the economy in which the executives frame investment opportunities, as well as whether the participants are receptive for the use of real options. The experiment used to test the above is based on certain theoretical hypotheses. These hypotheses should be linked in order to explain the feasible valuation differences. The first hypothesis is as follows:

Hypothesis I:

Participants’ valuations of an identical investment opportunity with the use of the DCF method, are higher when confronted with earlier business successes (hot deal market) compared to a situation of earlier business setbacks (cold deal market).

In the first part of the experiment, the participants are assigned to different groups. Participants of two groups are confronted with a history of respectively increased and decreased company values, as a vague result of economic conditions and former investment decisions. Because of various reasons, which will be elaborated in the sequel of this paper, these valuations could differ. In the following part of the experiment the participants will be subject to distinctive experimental manipulations based on their business experiences. Because of these manipulations, a further comparison between the valuations made in the two groups will be invalid. Furthermore, two control groups are imposed, partly in order to test for sample reliability (e.g. outliers) and to anticipate further problems with inference. The control groups for both the group which encountered a positive history and the group which encountered a negative history are only given an initial company value. The expectation is that the average valuations of these groups do not differ, which might be contrary to a comparison between the control groups and the groups which are initially framed. Furthermore, a comparison between the initial valuations of the ‘framed’ groups and their control groups, provides the opportunity to test which biases are involved. The above leads to the following hypotheses:

Hypothesis II:

Participants’ valuations of an identical investment opportunity with the use of the DCF method, are higher when confronted with earlier business successes (hot deal market) compared to a situation without any given previous business involvement

Hypothesis III:

Valuations of an investment opportunity by participants who are confronted with earlier business setbacks (cold deal market) differ from valuations of an identical opportunity by participants who have no earlier business involvement.

In order to justify above hypotheses certain implied questions has to be answered. What kind of investment opportunity is meant? What is the nature of the DCF method and how could the assumed difference in valuations be explained? The answer on the first question is related to the use of real options. In order to test whether participants neglect certain aspects of an investment opportunity, which could be offset by the use of real options, the description of the investment target must allow space for interpreting opportunities to grow/expand, stage and/or abandon the investment. The relationship between the characteristics of the investment opportunity and the applied real options will be clarified in a following part of the theoretical framework. As earlier introduced, the assumed reason of the dependence of executives’ (here participants’) valuations on the context of earlier experiences and the associated possible difference, are due to various cognitive biases. First these biases will be discussed in order to elaborate on the relationship between these biases and the condition of the M&A market. In other words; in which scenarios are executives more prone to which biases and how could one explain this?