Ted Prince

Dr. E. Ted Prince, the Founder and CEO of the Perth Leadership Institute www.perthleadership.org, located in Florida in the US, has also been CEO of several other companies, both public and private. He is the author of three books: “The Three Financial Styles of Very Successful Leaders” (McGraw-Hill, New York, 2005), “Business Personality and Leadership Success”, Amazon Kindle 2011 and  ”How Founders can Bring Success to the new Silicon Valley in China”, New World Press, Beijing, 2016 and 2018 in Chinese as well as numerous other publications in this area. 
 
He is a frequent speaker at industry conferences. He works with large corporations globally on financial transformation and leadership development programs and coaches senior executives and teams in the area of financial leadership. He has held the position of Visiting Professor at the University of Florida in the US in its Graduate Business School and as Visiting Professor at the Shanghai University of Finance and Economics in China.
 

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Is M&A Analysis Insanity?

By Dr. E. Ted Prince, Founder and CEO at Perth Leadership Institute

You don’t have to go far to read something about a failed M&A transaction. One that comes to mind is the Sears-Kmart transaction which is cratering as we speak. It’s been called “the greatest destruction of retail value in history.” Remember the mega-merger between Kraft and Heinz? The New York Times recently called it a mega-mess. Oh, and that includes its accounting – I will talk more about that below.

But it goes without saying that this area is full of failures. If you are in FP&A and the Big Kahuna tells you to do an analysis on a possible transaction, how do you go about it in a credible manner? 

As they say, the definition of insanity is doing the same things again and again and expecting a different result. So, should you use a traditional M&A transaction proforma analysis that usually fails?

I guess the M&A area badly needs a new approach, maybe a revolutionary one given how ineffective the current ones are. What could that be?  I’m sure you’re going to think I’m going to suggest behavioral finance, and you would be right. It’s clear that the one variable we never look at in M&A transactions in a formal way is the behaviors of the leaders, managers and employees on the two sides of a transaction. 

That’s kind of weird right? After all, the financials rarely work out as planned and the only big variable you have any sort of control over is behaviors of managers and leaders. So clearly, we need to account for that.

Let’s take an example. Remember when AT&T acquired NCR in 1991? That acquisition was a total flop and the deal was vacated in 1996. But how come everyone got it so wrong when on the surface it all looked hunky-dory?

Here’s an angle. NCR was an innovative tech company and all the leaders had been hired for their comfort with innovation and disruption. AT&T of course was the opposite; that’s why it wanted NCR. So, the status quo bias in one was low and the other high. Actually, you don’t really need to know much more. There was a dramatic difference between the two in a critical cognitive bias of the two sets of leaders and employees.

Cherchez la femme (kind of)

So duh, shouldn’t transaction architects, leaders and analysts be checking off the key cognitive biases in the two sides of a transaction to see the level of alignment? And since, as I have shown in previous articles in FP&A Trends, you can use these biases to predict the actual financial impact on a company, this means you can actually model an M&A transaction outcome. We call this a behavioral proforma.

But you’ve never heard of that right? That’s because the state of the art is still behind the state of knowledge. The academics have gotten us the knowledge, but they haven’t gotten us to the behavioral proforma because they don’t do the transactions. And the investment banks and financial analysts have either never heard about behavioral finance or they haven’t worked out how to use it as the basis of real-world models.

Now I’m not suggesting you suddenly drop traditional M&A proformas. I’m just suggesting that analysts construct a behavioral proforma and then use it as another set of data points on the future of the transaction. Actually, it’s not so difficult. We have done it ourselves. You just have to be a little bit low yourself on the status quo bias, so you feel comfortable working with a new approach.

Behavioral M&A for dummies

I guess most readers of this article are financial analysts themselves so they will know about traditional proformas. But if you want to really use the full potential of behavioral finance for M&A transactions you need to go much further than that. At a minimum you need to apply the behavioral approach to the following phases of the transaction lifecycle:

  1. Development of our acquisition strategy — what behaviors (i.e. cognitive biases) do we lack? What behaviors do we need so that the analysis won’t fail due to a lack of behavioral diversity or lack of cognitive biases that are aligned with the place where both sides want to go?
  2. The target screening process — what are our behavioral criteria for the right target? What are the mandatory behavioral, not just financial, product and market criteria we need for transaction success?
  3. Predicting future valuation outcome — how do we develop a behavioral proforma? How do we improve and optimize the financial outcome using behavioral modification, behavioral engineering and organization change?
  4. Designing the acquisition team and putting it together — how do we designing the acquisition team composition to match target financial styles – so that we don’t miss the wood for the trees?
  5. Post-acquisition and absorption strategy — what actions do we take considering the actual behaviors that have been acquired, and how best to align both sides to get the best financial result?

Where’s the beef?

No doubt most analysts have been taught to look at actual and predicted revenues and costs when analyzing a transaction. Their goal is to figure out profit (or loss) and EBITDA. But is this the appropriate approach?

Surely analysts should also be looking at the behavioral sources of economic and financial value and then also adding that into the analysis? That’s what seems to be missing from the current approach. Some might say that’s being done. But it isn’t, not formally. That’s the problem.

That means you have to look at key people and key parts of the organization to see what levels of cognitive bias there are especially in the status quo and the illusion of control bias. The first gives you a leading indicator of gross margin and the second a leading indicator of expenses. 

Often that is going to tell you a completely different story from revenue and cost forecasts. You really, really need to get a handle on those issues if you want to get a real-world perspective on how the transaction is going to fare in the future.

You might tell me that you are a financial person, not a psychoanalyst. But you don’t need to be one; that’s the wrong thing anyway. 

Financials are a symptom not a cause. They are a lagging, not a leading indicator. You are always looking in the rear-vision mirror. Is that what you want to be doing in analyzing an M&A deal? Looking at the past and not the future?

Behaviors cause things to happen and that results in actions which are measured using financial metrics. So, shouldn’t you need to know the behaviors to figure out what’s going to happen, at least in part? 

Otherwise you are only seeing a small part of the picture and, as we know, that can be very misleading if not financially fatal, as many organizations have found, to their cost. Not to mention that of their shareholders and investors.
 

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Can Behavioral Forensics Improve Financial Planning?

By Dr. E. Ted Prince, Founder and CEO at Perth Leadership Institute

What are behavioral forensics? Why would accountants and financial analysts and planners even need to consider behavior. Behavioral economics and behavioral finance tackle the issue of how people make economic and financial decisions if they are not completely rational. 

In these new disciplines, the academics consider the cognitive biases that all of us possess. These biases systematically skew our decisions because we are not aware of them. That applies to financial planners and analysts too.

Cognitive Biases

But what sort of biases? Lots of them, unfortunately, but that’s life. So, let’s take a couple to show you their impact. 

If you have a low status quo bias you like to invent new ways of doing things, even if they are not needed. So, you are always looking to swing for the benches. If you hit one, it’s a big hit. You invent something new like the iPhone and change the world. And when you do that you create so much value for consumers that they are willing to pay premium prices. So, the gross margins are exceptionally high. That’s worth knowing about someone right, especially if you are doing some financial planning for someone who is just like that.

People with a low status quo bias tend to be very, some would say hopelessly, optimistic. People who are as optimistic as that tend to have optimistic estimates of things like revenues; they will tend to be way too high. And they will almost always tend to be too optimistic on expenses so underestimate them, often hopelessly. So, these types of people will tend to generate over-optimistic estimates.

If you are a financial planner working with someone or with others who are like that, you can see it’s well worthwhile to know about that so that you can adjust your estimates accordingly. If you don’t, your planning will not be so good, maybe it will be way off the mark.

Another one is the illusion of control bias. This bias is a good guide to judging if a decision-maker is liable to over-use resources and to have relatively high levels of expense.

The status quo bias and the illusion of control bias between them can be used as a framework to judge the impact of someone’s behavior on gross margins and indirect expenses levels. So, if you are a financial planner or analyst that’s pretty important data, right? There would be a lot of investors who would love to see that information so they can make better investment decisions. Come to think of, in the wealth management area, there would be many buy-side equity analysts who would love to have that information so that they have a better chance of getting higher equity returns for their wealth management clients.

Behavioral forensics is a form of analysis which supplements traditional financial analysis to adjust estimates to adjust for the behavior of decision makers, or even the behaviors of analysts themselves. It is a more sophisticated form of analysis since it regards the results of traditional analysis as not having been customized for the particular behavioral characteristics of the decision-makes on whose decisions the results will depend.

Now you might think that traditional FP&A is fine as it is and doesn’t need any tweak or changes. But I have a question for you. It’s about General Electric.

General Electric: Fraud or Cognitive Bias?

In my last post on this topic I referenced GE and its checkered history of financial reporting. As it so happens since that last post, GE has been in the news again, this time yet again for its financial reporting. This time it is being accused of fraud. That’s kind of serious right?

The accuser is Harry Markopoulos. He’s the guy who blew the whistle on Bernie Madoff, so he’s got some serious street cred. GE are denying everything and who knows who’s right? But it doesn’t really matter. 

Right now, the only thing we have to go on is the GE figures. We don’t know the behaviors of the leaders who are responsible for the figures. 

Let’s accept for the moment that there’s no fraud. But what about the cognitive biases of these leaders? Are they all in the grip of the sunk-cost fallacy? That’s where you are prone to believe that since you’ve already invested a ton and it’s lost; you might as well spend some more. 

That’s not fraud but if they are so impacted, it would impact the financials in a big way without shareholders ever understanding that they are being affected by a hidden bias. Shouldn’t they know that? Shouldn’t you as a financial planner understand that also? So, these cognitive biases count. And we still don’t know what they are in GE, or for that matter, any public company, let alone private.

Financial Planning: Deliberate Manipulation or Unconscious Mistake

Behavioral economics and finance have opened the possibility of adjusting financial planning and analysis to detailed behavioral analysis for a particular person, team or company. 

As you can imagine one of the applications of behavioral forensics is to identify fraud, mismanagement or egregious behaviors that lead to major financial problems. 
It is very difficult to look underneath the figures unless you link the analysis with behavioral forensics.

You might think this would be the most common problem in financial planning, that is, discovering deliberate manipulation of the financials. But we need to recognize that probably the biggest problem is the preparation of financials by well-meaning and honest people whose systematic but unconscious cognitive biases lead them to systematically skew the financials in a particular way, e.g. excessive optimism or pessimism. 

Financial people are almost never trained to spot these types of issues since financial analysis is conceived of as being a purely technical issue where behavior cannot be allowed to intrude. But it does intrude, just in ways that most financial analysts don’t recognize.

Behavioral Transparency vs. Financial Transparency

In the financial disciplines we are still at an early stage with regards to integrating behavior. The Holy Grail of public accounting is financial transparency, where we know the antecedents of all the figures, and we understand precisely the methods by which the figures were prepared. But we are starting to realize that unless there is behavioral transparency, we can never achieve the aim of financial transparency because vital facts in the figures are driven by behavior we rarely understand. 

Proxy statements contain biographies which are at best a misleading and incomplete approach to revealing useful behavioral information. That is because they are usually prepared for public and investor relations purposes and too often, they have as an aim to burnish a person’s reputation rather than give us useful information.

I predict that behavioral forensics will emerge as a new and useful approach for financial planners and financial analysts as well as for investors, funds and equity analysts. I think professionals in the FP&A field need to start making themselves familiar with some of these new behavioral concepts and approaches in order to stay relevant to where financial disciplines are moving.

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Can FP&A Ever Be Predictive Without Integrating Behavior?

By Dr. E. Ted Prince, Founder and CEO at Perth Leadership Institute

The title might seem a little radical. After all, FP&A makes no provision for integrating behavior as a factor in planning and analysis. So why even raise the issue?

I have been CEO of several companies including one public company in the US. Of course, FP&A was a normal and routine activity in those companies. The most common activity was to plan for future revenues and expenses. Naturally we would go to the head of sales for his thoughts on the matter. When my financial people would present his estimates to me, I would always discount them by maybe 30% because I knew from experience that he was always too optimistic.

And I’d do the same sort of thing with expenses. Here I would ask my CFO for his estimates. In his case I would always increase them around 20-30% because I knew that from experience, he was always too pessimistic about costs and expense would always turn out to be higher than he projected. Usually my revised estimates were pretty good, since I had made these adjustments.

So, you can see that the adjustments I made were adjustments made to account for personal behavior. If I hadn’t made them the estimates would have been way wrong. I think what I did is very common in the business world. CEOs and top people presented with estimates of financial futures will take estimates from their people and will adjust them based on their knowledge of their particular behaviors.

In a nutshell, that’s why behavioral economics and behavioral finance were invented. It’s gradually dawned on everyone connected with economics and finance that our assumptions were way too simplistic. For one, we have assumed that people always make rational decisions. Of course, we don’t. But economics and finance have been founded on that bedrock principle.

And we always believed that when people made economic and financial decisions, we didn’t have any biases one way or the other when we made them. We didn’t let our emotions or thinking patterns affect whatever decision we made. Of course, that was totally wrong too.

Several Nobel prizes have now been awarded in these new disciplines of behavioral economics and finance. The first was to Daniel Kahneman in 2002 and the latest was awarded to Richard Thaler in 2017. These disciplines are based on the truth that humans don’t always make rational decisions. Additionally, we all have unconscious cognitive biases that systematically sway our decisions in ways that are not always rational and lead to suboptimal financial decisions. Al of this occurs without us generally being aware of it.

The idea that your analyses are not impacted by your behavior is belied by a new field of research called behavioral accounting. This focuses on the impacts of behavior on accounting frameworks and their data products. 

In other words, we can’t assume that even strict accounting rules are going to shield us from our cognitive biases. This is because we also re-interpret accounting rules according to our cognitive biases. But as most people don’t know what their biases are, it’s difficult for them to realize what is happening to the data they produce in terms of its reliability and level of predictability.

If you want an example go no further than that famed icon of American industry, General Electric. GE was the poster child for financial planning; it wrote the book so to speak. For many years it provided earnings guidance for analysts. We now know that it utilized “creative” accounting techniques to build cushions so that it could “smooth” its earning history. 

The use of these cushions was discretionary and therefore dependent on the behaviors of the leaders who dictated the use of these approaches. So, what looked to be predictable earnings was anything but. In fact, without this approach, the earnings would have been unpredictable. 

GE’s approach used to be common, but we know that many companies still use questionable techniques to smooth their earnings, albeit in not so obvious a manner. They are doing it because they understand that they must use some type of approach to reduce earnings volatility, which investors don’t like. 

But here’s the crux of the matter. Earnings volatility is often the result of behavioral change and volatility, on the part of the leaders of the company, and some of its top players. Sometimes companies use these techniques precisely because they understand that only “unnatural” adjustments, such as illicit or unconventional approaches can seemingly get rid of that volatility.

In other words, the continued existence of these techniques is due to a tacit recognition by many people that you can only make predictions if you somehow adjust for the volatility in earnings that comes from the volatility of human behavior.

This factor has spawned a formal metric, namely “beta”. Beta measures stock volatility. It was developed because people understand that volatility is a natural phenomenon. 

GE and many companies use the “smoothing” techniques to hide the impact of natural volatility on their earnings. They understand that if they accounted with legitimate financial accounting and planning techniques, they would not be able to provide the earnings guidance they would like to portray, namely stable, predictable earnings. They use these techniques to make their planning appear more rational than it should be, to be faithful to what is really happening in their operations.

So, there is impeccable academic and practical stock experience evidence for the belief that behaviors, not just products and assets, are a key part of profitability and financial outcomes. That’s why it’s relevant to FP&A, in fact, not just relevant, but vital. The issue is, how do you use this knowledge?

The first thing you must realize is that behavior includes analysts too, that means you yourself, not just the people who actually make the decisions. What are your cognitive biases and how will you find about them, especially how they impact your estimates and analyses?

How do you figure out the cognitive biases of others? That includes your co-workers, data colleagues, and the main actors in the organization for whom you are producing data and analyses. There are ways of doing this using behavioral and psychometric assessments. But the first step is to figure out your own biases and how they affect your own work.

What are some of the main ways you can leverage behavioral analysis to make FP&A much better? Here’s some places you can start:

  1. Behavioral forensics to improve financial outcomes: there are ways of using cognitive biases to predict the gross margin of both individual executives, the management team and the company. It’s entirely separate from product analysis. There is a way to use another cognitive bias to predict indirect expenses, again entirely separate from conventional cost analysis.
  2. Use behavioral analysis to predict M&A outcomes. By using these cognitive biases, you can construct a behavioral proforma to compare with the traditional M&A proforma. As we know traditional M&A analysis is very unreliable, so we badly need another approach to predict the outcome of M&A transactions. The behavioral proforma is used as a complement, not as a substitute.
  3. We can use behavioral analysis as a new approach to performance and operations analysis, both to predict profitability, and to predicting the likely contribution to profitability of individuals and teams.
  4. It’s clear with all this you can also employ behavioral forensics and analysis to predict investment outcomes; areas include portfolio analysis in private equity portfolios, hedge fund returns, and the returns from other types of equity investments.
  5. We have already referred to behavioral accounting. Behavioral forensics can also be used to predict the likelihood and existence of fraud and incorrect payments.
  6. Behavioral analysis is a much-needed upgrade to risk analysis and compliance. Traditional risk and compliance approaches don’t take behavior into account. This constitutes a huge conceptual gap in global risk management approaches. By using behavioral factors and analysis of cognitive biases we can also reduce risk levels everywhere.

Like all disciplines everywhere, FP&A must move with the times. It’s not enough to count on traditional FP&A approaches to preserve the credibility of FP&A analysis. Just like every other traditional approach, these must be upgraded and, in some cases, revolutionized. Utilizing new approaches based on behavioral economics and behavioral finance to is an excellent place to start.

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Author's Articles

October 23, 2019

You don’t have to go far to read something about a failed M&A transaction. One that comes to mind is the Sears-Kmart transaction which is cratering as we speak. It’s been called “the greatest destruction of retail value in history.” Remember the mega-merger between Kraft and Heinz? The New York Times recently called it a mega-mess. Oh, and that includes its accounting – I will talk more about that below.

September 18, 2019

What are behavioral forensics? Why would accountants and financial analysts and planners even need to consider behavior. Behavioral economics and behavioral finance tackle the issue of how people make economic and financial decisions if they are not completely rational. 

August 14, 2019
FP&A Tags:

The idea that your analyses are not impacted by your behavior is belied by a new field of research called behavioral accounting. This focuses on the impacts of behavior on accounting frameworks and their data products.