I guess all of us agree that if you are doing financial analysis, you need some actual financial numbers just to get started. But what if there’s a company all right, but there are no numbers? How so? How about a startup backed by venture capital? Or a new business, with a founder but no history?
We can’t argue that the venture capital guys aren’t playing fair by not giving us any numbers to analyze. Every business has to start sometime. Arguably venture capital has had the biggest impact on human existence since the invention of writing. Well, maybe. But it's right up there.
No history, no deal
With venture capital most of the time you don’t have any history! A lone unknown entrepreneur emerges from nowhere and starts something; a bit like Adam Neumann the now-anti-hero of the now-infamous WeWork.
Most entrepreneurs are a financial black hole because they’ve never started a company before or run one. So, you don’t have any history on them to analyze. Even when you do it will be so current you can’t even trust the figures because they are totally new. This situation is pretty similar to where investors in WeWork just found themselves.
So financial analysts are on their own. They have no privileged position from which they can tell investors they have some insight into the figures, because of course, they don’t! Because there are no figures!
You might be dealt a stroke of luck if the entrepreneur has started a company before. But maybe not. Maybe it’s a different market so there is no similarity. The only thing you have to go on is that the only similarity is that it’s the same founder and person, having the same personality, the same good looks and maybe the same silver tongue. So, the only similarity is the same behaviors. How do you use all of that?
Same good looks….
In my previous posts on FP&A and behavioral finance I’ve advised that you need to check out someone’s cognitive biases in order to get a handle on predicting their financial performance. The problem is that there’s lots of cognitive biases that have been identified and catalogued. Actually, there’s well over 100. And virtually none of these can be measured in a standard and standardized way, except the ones I refer to below.
Which cognitive biases do I actually use? Is there a priority list? Can we find a hierarchy of cognitive biases that would allow us to do a quick test on someone like Adam Neumann instead of having to do a 5-year PhD thesis, which is what academics like to do but which the vast majority of us have not time for?
Well, yes, there is a hierarchy. It’s one from yours truly, based on my own evaluation of what’s going on, or not, in behavioral finance.
The first level of the hierarchy is the status quo bias and the illusion of control bias. These respectively help you predict the likely gross margins and expenses that will occur on a particular entrepreneur’s watch. So, start with them. The nice thing is that these can be measured precisely and quickly.
The second level is more arguable, but I would go for two; the confirmation bias and the sunk costs fallacy. The first is the tendency not to look for opposing cases and the second is the tendency to double down, usually in a big way and usually irrationally. The bad news about these is that there is no standard, easy, off-the-shelf way to measure them without doing your own research project.
The third level is the over-100 cognitive biases we haven’t discussed. There are some useful ones, but they’re not easily measured. So, you can use the second and third levels, but you will be in the realm of discussion and qualitative measurements. So not very reliable. Best usually to stick with the first level.
Financial black holes – deal with it!
As you as an analyst get more into our complex world of companies and finance, you are going to meet more and more situations which have no easy answers and maybe no answers at all.
Lots of really smart people got WeWork wrong. WeWork and Adam Neumann are hardly unique and there will be many others. Some of them are going to come your way.
Some Practical Recommendations
So, you are talking to a young, bushy-tailed founder and you want to find out whether or not he will make money. First of all, check out his status quo bias. Best to do it with a psychometric assessment but you can rank him according to his value-adding driver – low, medium, high. If its high he’s got a good chance of achieving a high gross margin. How high? Check out the top 10% of gross margins in his industry segment and you’ll be able to put a number to it. Let’s say the average gross margin for his segment is 36% but the top 10% in that segment have an average 54%. So, he’s going to be somewhere around there.
What about his expenses? Are they going to be WeWork high? That is, his illusion of control bias is high, and his expenses are high too. Again, check out the average level of indirect expense as a proportion of sales in his industry segment. Let’s say its 32%, but the highest 10% is 42%. You’re in luck. His GM is 54% and his expenses are 42% - too high for sure but his GM is even higher.
Now that’s just a rough-and-ready guide to the method. If you try to do it yourself, you’ll probably get it wrong because it’s too subjective. The formal assessment is the gold standard, so to speak.
Read more widely
Behavioral finance isn’t the only game in town although it’s a new game with a constructive and insightful framework. Financial analysts need to get more sophisticated in a human sense. That means they need to be able to leaven their financial analyses with behavioral analyses.
Some of these will be based on behavioral finance. Some will be based on personality and competency approaches. Still others will be based on other approaches such as psychoanalytic methods and NLP (Neuro-Linguistic Programming).
As an analyst you’re paid to get real-world and useful answers, not just interpret everything through the same lens, especially if it doesn’t focus well, or at all. People will judge you depending on how practical and useful your analyses are. New companies are a fact of life and the lifeblood of most countries today. If you can’t read them, you’re going to pay the price, which will be lack of real-world credibility.
Read more widely, not just finance. Read history, including but not only financial history to see what really happened. Use creative imagination to see what could happen.
That’s how you get to be a practical yet creative, breakthrough financial analyst.