Blog

Overconfidence:  Its impact on financial modelling, and potential benefits in management.

By 5th November 2018 No Comments

Does following traditional finance approaches to fundamental valuation avoid the potential for overconfidence biasing M&A decisions?

Following traditional finance approaches can help avoid the impact of overconfidence in intuitive approaches to mergers and acquisitions. However, even with traditional finance approaches such as Discounted Cash Flow (DCF) models (or NPV, IRR), there is potential for overconfidence biasing Merger and Acquisition decisions. When applying DCF methods to analysing a project, the variables that need to be estimated are the expected future cash flows and the riskiness of the undertaking to discount these future cash flows appropriately.Hence, overconfidence might bias M&A decisions in the following ways:

  1. Future cash flow estimations or their timing could be overly optimistic. This could either be due to overconfidence in the outlook in driving the project forward.
  2. Overconfidence could influence the risk assessment and result in an inappropriately low discount rate. Executives exhibit severe miscalibration which leads to a systematic underestimation of the volatility of random events.Miscalibration in this context is defined as excessive confidence in having accurate information.

Moreover, the use of a sophisticated or well-recognised ‘model’ might lead to overconfidence in the outcome of the analysis.

Overall, traditional financial approaches,  while more systematic and largely accepted methodologically, are still subject to overconfidence via the model inputs. To reduce the potential impact of overconfidence companies should combine traditional approaches (such as real option frameworks) with objective historical data whenever possible. In the absence of objective data companies should be aware of the potential for overconfidence and use appropriate debiasing techniques.

Are there any benefits in having an overconfident CEO?

Overconfidence is often cited as the factor leading to disastrous decisions including aggressive accounting and corporate failures. Some examples include the collapses of Enron, Bear Stearns and Lehman Brothers.2 Overconfidence – and its close relative excessive optimism – has been associated with overestimating the profitability of projects, tax benefits from debt and underestimating the costs associated with financial distress resulting in the tendency to be overleveraged.

There are, however, also a number of benefits of overconfident CEOs. Firms with overconfident CEOs invest more in research and development and are more innovative.3 They have better relationships with suppliers and higher staff retention.4 Moreover, overconfident CEOs may be perceived as more capable and are more likely to reach out to investors with timely results and transparent company strategy – thus increasing market efficiency.

Overall, there is an optimal level of overconfidence for CEOs. Like everyone else, CEOs are not only prone to overconfidence but also to other (sometimes opposing) behavioural biases such as risk-aversion. Managerial overconfidence leads to increased risk-taking and this increase might be necessary to “balance” opposing biases such as risk-aversion.5 Therefore, one should not only investigate the impact of overconfidence in isolation but consider a wider range of biases combined and their potential effects holistically.

1. https://faculty.fuqua.duke.edu/~charvey/Research/Published_Papers/P110_Managerial_miscalibration.pdf
2. https://blogs.wsj.com/moneybeat/2016/08/24/the-hidden-benefits-of-an-overconfident-ceo/
3. https://pubsonline.informs.org/doi/abs/10.1287/mnsc.1110.1374?journalCode=mnsc
4. https://ink.library.smu.edu.sg/cgi/viewcontent.cgi?article=6378&context=lkcsb_research
5. https://www.nber.org/papers/w17333

Stay in the loop

Sign up and get access to new content