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Business Valuation: Art, Science, or Craft?


Today's post is by Hanna Murina, a PhD student at Kyiv National Economic University, Ukraine. Hanna is a finance professional with a diverse background spanning investment banking, corporate finance, commercial banking, financial sector regulation and financial consulting. Her well-rounded education includes degrees from the Ukrainian Banking Academy, Northumbria University, NaUKMA, and EERC, as well as ongoing PhD studies at Kyiv National Economic University. Hanna earned her CFA charter in 2008, demonstrating her commitment to excellence in the field. Her interest in business valuation, which emerged during her early years at an M&A boutique, has since evolved into a focus on developing sustainable CAPEX proposal to refine terminal value estimation.


I agree with Aswath Damodaran[1] that business valuation should not be classified as an art or a science, but rather as a craft. In this article, I will explore the rationale behind this assertion and why this recognition holds importance for the valuation profession, considering the interplay between subjectivity and objectivity, fiduciary duty, and human behavioural fallacies.


Damodaran argues that valuation cannot be considered a science because correct inputs do not always produce accurate outputs. Also, it cannot be viewed as an art because it is not solely determined by the individual greatness of the author. Instead, the valuation profession is best described as a craft that is honed through experience. And I would like to add that as a craft, it aims to produce creative and reliable results with both aspects being equally important and complementary.


The creative aspect of valuation results is closely related to the subjectivity inherent in the valuation process, whether at the individual or collective level. Subjectivity manifests in various ways, including the choice of valuation model, its design, time horizon, and the selection of inputs and estimates. Individual subjectivity arises during the creative process of individual valuators. While prescribed standards, manuals, and accepted business practices can mitigate individual subjectivity to some extent, it cannot be completely eliminated. Often the means of reducing individual subjectivity take the form of collective subjectivity, which involves designing, framing, and accepting methods, rules, and baseline assumptions within a group of professionals.


However, collective subjectivity may lack proper verification and proof of accuracy. This resonates with Ludwik Fleck's notion of thought collectives and thought styles[2]. For example, in my research field, there is a widely accepted rule of thumb that equates estimated CAPEX with the depreciation charge. Although this rule is adopted based on collective agreement, it lacks the necessary verification and proof to become a reliable knowledge base for the profession. Valuation methods may evolve from individual subjectivity, which generates unique and creative solutions, to collective subjectivity when these solutions gain widespread acceptance. However, reliable knowledge only emerges through rigorous verification and testing.



The second aspect of valuation results is reliability, which has immense impact on the quality of subjectivity and makes it very different from that in art.



To ensure reliability, subjective judgments are bounded to have reasoning and justification. This creative thinking process is distinct from the emotions and feelings found in art. While both thinking and feeling are subjective, they rely on different processes and produce very different creative outputs.


By recognising valuation as a craft that seeks to produce creative and reliable results, we can benefit the profession in various ways by suggesting strategies to navigate and cope with the challenges.


The challenge of subjective-objective interplay can be addressed by acknowledging the presence of subjectivity, transparently disclosing it, and dealing with it in a manner that transforms it into an advantage rather than a flaw. Valuation results should not be treated as objective a single value or a range of values but can be complemented with disclosures on the sources and extent of subjectivity, including valuation standards, business practices, data inputs and assumptions, verification process, and sensitivity and scenario analysis.



Fiduciary duty may drive valuators to minimise the use of individual subjective judgments and rely more on historical performance, "objective" estimates, collective subjectivity, and data mining.



However, one may question whether it is preferable to solely rely on objective historical inputs or utilize judgmental estimates. Will adhering to a rigid template or developing a case-specific model design enhance the reliability of valuation results? Objective historical data may not always exhibit a strong relationship with future performance, especially when structural changes or other events disrupt historical trends. In such cases, subjective reasoned judgments may provide a better guide. Achieving a balance between objective historical data, which is still subjectively selected from a pool of evidence, and subjective reasoned judgments is a valuable craft developed through experience. Similar considerations apply to the use of templates and case-specific designs.



The presence of subjectivity in valuation also highlights the potential for human behavioral fallacies. There are at least two possibilities to address human fallacies: (1) developing awareness of possible fallacies and (2) the requirement to apply reasoned judgments. Unreasoned judgments are more susceptible to fallacies compared to judgments based on substantive reasoning. By employing sound reasoning, valuation practitioners can enhance the reliability of their results, in contrast to the role of an artist who develops a unique viewpoint guided by emotions.


As a craft, the valuation profession can leverage the best elements of both science and art in producing creative and reliable results with reasoned judgments and verified methods. Valuation professionals, as craftspeople, can master reasoned judgments, while professional associations, expert groups, and academia are expected to continuously verify various solutions and develop a reliable knowledge base in valuation methods.

 

Sources:


[1] Damodaran, A. (2018). Valuation: art, science or magic? URL: https://pages.stern.nyu.edu/~adamodar/pdfiles/country/val2dayCzech2018.pdf


[2] Sady, W. (2021). Ludwik Fleck. The Stanford Encyclopedia of Philosophy (Winter 2021 Edition), Edward N. Zalta (ed.), URL: https://plato.stanford.edu/archives/win2021/entries/fleck

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