Subjectivity in the valuation of companies and investments

Subjectivity

There are quite a few false myths about the valuation of companies and investments. One of them is the one that says that the valuation of companies is objective. The reasoning behind this myth is that as the valuation models are quantitative, the valuation is objective.In this article we will analyze this false myth, we will see if there is any way to reduce subjectivity and the implications that this fact has when investing.

Asset valuation as a science

Asset valuation is not an exact science, the result of which is objective and strict values, but, although this science is based on certain facts, and uses logical procedures, these also require subjective judgments. The valuation of an asset will be influenced in most cases by the subjective valuations of its authors. In fact, it is very rare for different authors to agree when valuing an asset.

How can we reduce subjectivity?

One solution would be to eliminate all sorts of biases for evaluations. However, although this would be the ideal it is not possible, since it will always be necessary to carry out some type of qualitative and subjective assessment for a complete analysis. In addition, much of the information that we will have to analyze must pass through a subjective filter in which we assess its suitability and reliability to form part of the assessment process.

Despite the fact that it is impossible to achieve total objectivity, we can try to reduce biases in valuations through a series of precautionary measures that protect us as much as possible from these biases. For example, it is possible to reduce subjectivity if we analyze companies that are not part of our portfolio, since this fact may imply a positive bias in the valuation.

Implications of the subjectivity of investment valuations

The fact that the valuation is not totally objective does not make it useless, but simply raises two problems that must be taken into account when guiding ourselves through the valuations, both ours and those made by third parties.

With regard to the reliability of the valuations made by third parties, the best solution to this problem is to analyze for yourself the investments that we are going to make without relying solely on third-party analyzes. Another solution is to at least base our investments on the conclusions of analysts who give us great confidence, although it is always better to do the analysis ourselves.

As for the reliability of the assessments made by ourselves, the solution to this problem is to buy companies that offer a good safety margin, combined with an adequate portfolio diversification, which allow us to cushion our valuation errors.