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Brian Abbott
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In investing, I have a heavy focus on reinsurance companies, and I enjoy learning how to value their investment portfolio and underwriting ability, taking inspiration from the reinsurance companies that Warren Buffett used to help build Berkshire Hathaway's investing empire. The other focused... More
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  • Discounting Everything By 30% 2 comments
    Jan 21, 2013 12:32 PM

    I have a theory I plan to test on some earnings announcements and analyst reports, but in advance of that, I wanted to get it out on my instablog. The theory is that all estimates should be discounted by 30%. This number is my first guess of how to incorporate all the cognitive biases that are known to exist (overconfidence, confirmation bias, hindsight bias, and many others) into a rough estimate.

    Interestingly, in my own work in biotechnology research which involve clinical trials, the discount should be much, much more than 30%. If a collaborator says a trial should take one year to complete, you can bet that it will take two. In fact, I budget it that way. If they say they can accrue 200 subjects (patients), you better start looking for a publication that will accept as few as 50. The benefit to the organization is that we control our enthusiasm and also avoid the smaller, riskier projects that probably would never have even obtained publishable results.

    The theory is a way of using the research that other people perform, while applying a discounting mechanism to account for the high likelihood that even if they are directionally correct, they have a high likelihood of being numerically incorrect.

    This theory also tangentially gets into value investing theory, in that a margin of safety is sought, for similar reasons: even the best analysis is still flawed in some way.

    That's all for now, but I hope to write more on this once I find some good examples based on stock analyst reports and the ongoing earnings season. Who knows - maybe the discount should be 20 or 50%. Thirty percent was just my first guess at what it should be.

    Disclosure: I am long INTC.

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  • The Sociology of Finance
    , contributor
    Comments (955) | Send Message
    I agree that psychological factors often cause estimates to be overly optimistic, but I think that there are institutional factors as well- herding around a consensus for career reasons, no analyst makes powerful enemies by being too optimistic, uniformity in valuation methods in the mainstream analyst community, etc.


    That being said, I think that these factors can work in reverse, although less often. The trick is figuring out when. I would guess under-valuation happens more often when there are few/no analysts covering a stock because it is too small/in a niche industry, so they aren't there to give a false sense of certainty regarding the future.


    22 Jan 2013, 09:56 AM Reply Like
  • Brian Abbott
    , contributor
    Comments (156) | Send Message
    Author’s reply » Micheal- thanks for commenting.


    Another point of clarification is the the "delta" would be one third where estimates are concerned. Obviously a company like Intel has a lot of momentum and maybe long term contracts so I wouldn't discount all of that. What I would discount are incremental changes that rely to some degree on unverifiable estimates - that is where the cognitive biases creep in. So on something like an overall EPS estimate I wouldn't change by 30%, but if there is a list of speculative guesses for things that add up to 5% or 10% of the incremental growth - perhaps that portion should be discounted by 30% (usually downward).
    22 Jan 2013, 11:16 AM Reply Like
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