Will the financial crisis foster new approaches to financial analysis? We invited Ted Prince, founder of Perth Leadership Institute and a practitioner of behavioral analysis of company management, to share his views on changes in financial analysis.
Behavioral Financial Analysis: the Next Frontier
Dr. E. Ted Prince
The Failure of Financial Analysis
Unremarked in the cascade of financial disasters that has befallen the US is the utter failure of financial and valuation analysis. The 2008 Crash demonstrated that traditional valuation analysis provides no way to model nonlinearities – the very things we want to predict in looking at valuation.
The crisis also highlighed severe limitations in the profitability measure, the bedrock of modern financial analysis. Profitability metrics are backward- and not forward-looking and may indeed be measures of financial dysfunction as well as of apparent financial performance. Financial analysis rarely takes into account the fundamental asynchronicity between financial actions and the financial consequences that flow from them. The behavior that leads to profitability often precedes it by many years but analysts have not been able to find a way to model this effect, even at the crudest levels..
It is clear that the current structure of financial analysis has deep and tragic flaws. The question is no longer whether the old approaches have failed. The question now is what comes next.
The Importance of the Irrational
While professional financial analysts have stuck to their outdated guns, the world is moving on. The emerging fields of behavioral finance and behavioral economics have received several Nobel Prizes over the last 20 years, yet have not yet been incorporated into modern financial analysis.
Behavioral finance relaxes the assumption that financial decisions are made by rational actors. Financial decisions may be based on considerations that are at least as much irrational as rational. Modern behavioral financial analysis is starting to unravel the messy neurological phenomena that lead to systematic but irrational biases which cause nonlinearities in financial behavior.
However even these new approaches have limitations. The most severe is that they can only make predictions based on group behaviors, not individual behaviors. Thus they may be able to make predictions about an industry or about millions of consumers but cannot make them at the level of the individual or at the individual company level.
Of course that is precisely what current financial analysis needs in order to be able to perform at an acceptable level. Once that is achieved then we can start looking at the valuation impact of individual CEOs, or of management teams composed of relatively few individuals. That is, we can model the impact of individuals and management teams on valuation outcomes.
A New Definition of Valuation
There is a revolutionary idea behind this. That idea is that the value of a business is not a reflection of its assets or profitability, or of discounted cash flows, or even of what someone would pay for the business.
Instead valuation is the result of the behaviors of the CEO and the management team. If we wish to understand better the valuation trajectory of a company, or indeed of an industry, we need to understand the behaviors of the managers who run these entities.
In this conception valuation is a neurological phenomenon, subject to the laws of behavioral finance. To understand the valuation trajectory of a company or an industry we must understand the financial behavioral drivers of its managers. That requires forensic behavioral financial analysis of individual managers which is aggregated at the team level. This in turn requires an underlying model of how these behavioral drivers are linked to financial and valuation outcomes.
Although the current status of behavioral finance has not yet achieved this level, another group of researchers has. The disciplines involved are called neuro-economics and neuroscience. This research seeks to explain the actual physical locations in the brain connected with different types of financial and economic decisions, and the pleasure pathways that are activated when they are stimulated.
Although in the early stages, this research is showing clearly that there are precise neurological mechanisms that impact financial decisions and that these mechanisms result in systematic biases in decision-making. This neurological research is a forensic approach albeit at a purely physical level with no broad theory to provide a model of how it all works.
The need now is for an overarching model that links these findings to a model of behavior and financial outcomes. Work along these lines is being conducted by my own company that elucidates these mechanisms and provides a cogent model explaining them. This provides a methodological underpinning for the physical work in neuro-economics.
The Passing of the Financial Dinosaurs?
There has been a tragic disconnect in academic disciplines affecting financial research. Business analysts generally deprecate psychology and behavior as being soft subjects that are not worthy of their attention. Psychologists disdain financial issues as being essentially tawdry. It has been left to the behavioral finance and neuro-economics researchers to break this taboo but the fact remains that these are currently still small groups.
Until this disconnect is resolved it will be difficult for the financial research community to make any real progress. It is notable that it is the much maligned psychologists that have been the ones to start to close this divide, not the financial analysts. The financial research community has been very resistant to fundamental changes in its approaches.
My prediction is that the source of innovation in the financial research market will come not from the financial and investment community but from the behavioral, clinical and decision theory research communities. The chances are we will see this research come to fruition in the next 5-10 years.
This means we will likely go through at least one further financial crisis in the meantime. However the result could well be that the financial community would be further decimated in the next decade, capping a process that started with the onset of the current crisis.
Dr. E. Ted Prince, the Founder and CEO of the Perth Leadership Institute, located in Gainesville, Florida has also been CEO of several other companies, both public and private. He is the author of ‘The Three Financial Styles of Very Successful Leaders (McGraw-Hill, 2005) and numerous other publications in the areas of management, leadership, technology, economics and finance. He is a frequent speaker at industry conferences. He works with large corporations globally on leadership development programs and coaches senior executives and teams in the areas of improving their financial and valuation impact.