MORE ABOUT NOISE

Point of Departure:

The curated journey to discover the determinants of firm value and value creation started with an examination of “Noise” because in our professional experience noise presents itself in ways that significantly interfere with helping business owners understanding how firm value is created and determined. Thus, noise was defined as “…any distraction from objectively evaluating company value or running the business at an optimum level…”.

 Noise Example:

A simple example is illustrative. An owner considers asking for an opinion of value of a firm and adds a comment  “… I’d like to sell my business, but not for less than $30,000,000.” After some questions to the owner about the firm’s operational performance two things typically become clear. First, in general the firm’s profitability will not support a $30MM transaction price. Second, when confronted with the reality of inadequate profitability of the firm, the owner’s response may reference a friend who had received an incredibly high multiples of EBITDA upon sale of a business and that high multiple was the key to high valuation.   Owners are inundated with noise that distracts from objectively evaluating the company’s value. And that noise is powerful.

A Deeper Curated Journey into Noise:

1. The Noise-Insight Ratio:

The problem of Noise is more complex than just a business owner’s confusion or being misinformed. It is a seminal issue because of the Noise-Insight Ratio. Noise Data grows exponentially, while Insight Data grows not at all, or incrementally and slowly. The Noise hides the insight. Or simply put, the haystack of noise grows very fast, and the needle (insight) gets harder and harder to find. It is simply buried in the vast amount of noise.

Statistically speaking “noise” is unexplained variability within a data sample which degrades the quality and usefulness of any insight (signal) that may exist. And the unexplained variability degrades the data itself. While an insight may be present, it is obscured by the noise from random data and “unstructured text”.  What is desired is to see the signal (Insight). Noise hides the insight.

TVP explores both internal and external noise on our journey and how those distractions may impede company performance and, as a result, firm value. But the problem goes much deeper as it is rooted in the psychology  of human behavior, which is the topic of this  Curated Insight.  References for this writing and  Further Study are detailed below.

1. The Flaw in Human Judgement

The work of Daniel Kahneman, Oliver Sibony, and Cass R. Sunstein is our point of reference. Their seminal work, Noise: A Flaw in Human Judgement (2021)) is important, especially Chapter 11: Objective Ignorance.

The flaw in human judgement is that noise intrudes on thoughtful decision-making processes, which result in faulty judgements, or as the authors put it the “…sobering findings about the limited achievements of human judgement” (Chapter 11, Page 137). The flaw is exacerbated when there is less than perfect knowledge and information, which heightens the uncertainty and risk of less-than-optimal resulting judgements.

Of the several ways to make decisions the , “going with one’s gut” or “intuition” is often the default executive decision-making model. Intuition in managerial decision making is defined in Noise  as a  process that produces  “…a judgement for a given course of action that comes to mind with an aura or conviction of rightness, or plausibility, but without clearly knowing why.”

( Chapter 11, Page 137-8). The “gut” is an internal signal, an emotional experience that is satisfying (to the decision maker) even if it ignores evidence to the contrary…” of it not being a good  decision”.

The most important implication is that “confidence” (in gut feelings/intuition) is no guarantee of accuracy. “Both bias and noise contribute to prediction errors. The largest source of such errors is not the limit on how good predictive judgements are. It is the limit on how good they could be. The limit…is “objective ignorance”. (Emphasis supplied). Objective ignorance renders an “…intractable uncertainty that includes everything that cannot be known…” when the decision is made. (Chapter 11, Page 139-140).

Intractable uncertainty and imperfect information (what could be known but isn’t) limits the achievable prediction. It isn’t just a matter of noise and bias, but something much more fundamental. As Professor Kahneman, et al also note, the problems of overconfidence include the denial of the role played by ignorance and randomness. For more on randomness see: Fooled by Randomness, by Nassim Nicholas Taleb, cited below (2001).

 TVP sees this phenomenon  as part of the discussion by  Emre Soyer and Robin Hogarth noted in The Myth of Experience: That experience often renders the wrong lessons, which Linda Ginzel also notes in her work on leadership.

TVP suggests that these dynamics become part of the “noise” that distracts owners from focusing on the key determinants of firm value and value creation. Too often the noise is what they want to hear but is not what they need to know to make informed and better decisions about firm value and value creation.