THE PSYCHOLOGY OF INVESTING AND FINANCIAL DECISION MAKING
Abstract
Proper financial decision making ensures the stability of the business. It facilitates the growth and security of the firm through viable and sustainable investments. Poor financial decision making and planning before investing may earn the company a profit for a short time but may not generate long-term sustainability. Thus, the selection of the right investment opportunities is critical for longer-term value maximization. This paper examines the case of financial decision making and psychology involved in investing. It reflects on the case of two companies, Valeant and Theranos, that failed to adhere to the key tenets of investment decision making, which led to their downfall. The paper reflects on the executives’ role in the downfall of the companies through poor decision making. There is also an examination of the psychological and behavioral financial concepts that play a role in decision making. Thus, the paper offers lessons for company executives in handling issues that bring about financial decision making.
Keywords: Valuation, behavioral finance, emotional finance
The Psychology of Investing and Financial Decision Making
Proper financial decision making before investing is very important not only for a company but also for an individual. Successful investments increase the revenue or the profits earned, and this, in turn, leads to the development and growth of the company (Carreyrou, 2019, 15). Also, the appropriate financial decisions must be made for a firm’s sustainability and growth. The financial decisions may include but are not limited to valuations, spending, debt ratios, and overall capital structure. Valeant and Theranos illustrate instances in which financial decisions were not done rightly, which had adverse impacts on the firms.
1. Market Valuation of Valeant and Theranos
a. Market Valuation
The market valuation of Valeant and Theranos companies was very high for a very short time, which caused it to drop drastically. These companies built their reputation from the stories they told to the public, which became a fraud. For Valeant company, its market value started to reduce when the company started buying other companies, which were its competitors, and raising its drug prices. According to Fombrun (2012, 95), the reputation of the firm is represented by the accumulative perceptions by the public. These appraisals can raise the firm’s reputation to another level (Hendry, J., 2013, 67). Assessment of reputation is related positively to the intensity of advertising, prior accounting profitability, and size. They are related negatively to prior performance adjusted risk (Cao, Myers, and Omer, 2012, 956). The Valeant and Theranos companies destroyed their reputation through misleading information. The investors lost their trust in these two companies, after which they withdrew their support. This led to the drastic reduction of the market value of these companies. The events were linked to poor financial decision making since the executives should not have engaged in unethical business practices that place their firms at risk.
Besides, poor customer satisfaction reduced the market value of the two companies. Studies have also shown that market value is directly related to the customer’s satisfaction (Carreyrou, 2019, 21). Some buyers of the drugs sold by Valeant Company could no longer purchase the drugs due to high prices. The increase in the prices of these drugs reduces the satisfaction rate of the customers. The reputation status of Valeant Company was also lowered because of the reduced customer satisfaction rate. For the company’s growth, the reputation of the brand is very vital (Carreyrou, 2019, 21). Keeping a positive reputation of the brand increases the loyalty of customers and also attracts new clients. It creates confidence in the company and its products hence putting it as a leader in that market. People will lose trust in the product if its price keeps increasing every day. This affects the performance of the company and also lowers the market value.
b. Rationality of Valuations
Based on the financial decisions made, the market valuation of Valeant and Theranos was irrational. The rise of their market values was rapid and extreme for a short period before falling drastically below the normal level. This was because the valuation was driven by the executives themselves. For a rational decision, the market or investors, through forces of demand and supply, should have influenced the valuation (Lieberman, Garcia‐Castro, and Balasubramanian, 2017, 1193). The valuation should have also reflected hard data such as revenues and earnings, which the company has generated in the past that can be used as projections of the future.
2. Investors of Valeant and Theranos Firms
Investors of both Valeant and Theranos companies were prominent personnel from the United States, such as the secretaries of the states. They were lured into investing with the companies because of the CEOs’ promising stories. The investors also agreed to invest with these companies because of the promised big returns that they would obtain at the end. The faster growth and development rates of these companies promised investors bigger returns from their investments.
3. The Disentangle of Valeant and Theranos Companies
The Valeant Company unraveled so quickly because of the misconduct and greed of its CEO. With the nomination of Michael Pearson as the new CEO of Valeant in 2008, he developed a new policy of running the company. Instead of developing and distributing their own manufactured drug, he decided to distribute already proven drugs. He would buy a pharmaceutical company producing medicines and increase the price of its drugs. He built the firm through a hostile takeover, acquired huge debts, and implemented a huge increase in the prices of the drug to create more profit. The strategy to get rich quickly employed by Pearson was preceded by preventing costly and lengthy research from developing a drug. The company used a shortcut to acquiring its revenue, and this led to its downfall. For several years, the Valeant industry was perceived as the best pharmaceutical company. Its achievement was so fast, and its growth was also steady. Nevertheless, quick and dirty achievements or accomplishments are always based on the mirrors and smoke, instead of strong establishments and hard work. Valeant is a perfect example of a more concerned company with faster growth with no much consideration for sustainable development.
Additionally, Valeant proclaimed that it had wrongly booked fifty-eight million dollars in profits obtained by its uncertain association with Philidor Company. Philidor was a Pharmaceutical supplier that distributes products that are suspected to be under the control of Valeant as the actual party obtaining interest. The fifty-eight million dollars were booked before the company was sold to them. The issue showed that there was more to the accounting of the Valeant. This called for the review of other issues related to accounting.
Similarly, Theranos Company was entangled due to misconduct and greed. Theranos was not able to adhere to its story of inventing a device that could measure numerous disorders just from one blood sample. The company would produce laboratory results that are not reliable. They could use other producers’ equipment to test their patients while their data and information were not always taken to be reviewed before publishing. Moreover, the company involved itself with the Food and Drug Administration (FDA). FDA requires that products should be thoroughly verified and validated prior to its launch to ensure that it meets all the regulatory requirements. This was the major challenge of Theranos as it did not meet the regulatory requirement. They used two main models of engineering to develop their device. These were concurrent and waterfall models. The two models have their disadvantages and benefits. The concurrent type functions with proper production practices and control of the design. Proper communication among different departments of the group shows that problems can be identified early enough and addressed in time (Tuckett and Taffler, 2008 20). Skills and mechanical expertise are both needed from the start of the work to ensure that the final product produced is up to the required standard. This helps the redesigning of the product and the costs associated with it. Theranos failed to take its products for validation and verification, which led to its downfall.
4. The Roles Played by the Background and the CEOs of Valeant and Theranos
The CEO of these two companies played a significant role in driving their companies to their current state. The companies invested in unrealistic investments, which earned them big revenue at first. When the investors noticed how these companies were growing quickly, they were induced to invest with them. Thus, the companies seemed credible to investors, given the track record they had developed. The returns of their investments were promising. The companies were making huge profits and were developing rapidly due to the strategies used by CEOs. Their strategies were aimed to make them rich faster even if they were exploiting others. Increasing the prices of the drugs by the Valeant company was not a good strategy for the company, but still, Pearson used it to gain more profit (Tuckett and Taffler, 2008, 21). The poor could not afford these drugs hence opting for alternative medicine to use. These led to a drop in customer loyalty, and in turn, the clients were not satisfied with the product offered by this company. Theranos Company, on the other hand, lied to the public to gain the interest of the investors. She told a story that lured prominent investors into investing with the company. This drastically increased the market value of this company. Unfortunately, the company could not design a device that can test several disorders just from a single blood sample. The company lost its reputation, and the investors withdrew their investments, leaving the company in debt. These two companies failed because of their greedy CEOs, who were using their stories to gain investors’ attention.
5. Importance of the Phantastic Object Concept
The concept of the Phantastic object can help to explain the dramas involving Valeant and Theranos. The concept relates to the mental representation of an imagined aspect to fulfill the protagonist’s desires (Taffler, 2018, 631). Selling and buying products or assets were done by the companies, which involved developing visionary goals to achieve a selfish goal. The management created emotional investment connections, which it considered to be part of the assessment. In Valeant Company, the CEO pursued quick gains by acquiring other firms and overpricing the drugs. In doing so, he built an illusion that his company was performing well, which duped the investors and satisfied the personal goals. Theranos Company produced unreliable results, failing to meet the regulatory requirement. This can be related to the phantastic object concept since the executives were not concerned with safety but selfish interests.
6. Lesson Learnt from the Failure of Valeant and Theranos Companies
a. Power of Decision Making
The first lesson learned from these two companies’ failure is that proper decision-making is essential prior to any investment plan (Lusardi, 2012, 43). The CEOs of these two companies made wrong decisions before investing, and this resulted in their failure. When Mr. Pearson became the CEO of Valeant company, instead of sticking to the company’s original plan, he got into the business of buying rival companies and raising the prices of their products. The deal was too good, and it was earning the company huge revenue for a very short time. This was a good investment if it were not to destroy the reputation of the company. The CEO wanted something that would make the company richer after a very short time. Accordingly, the drug invention cost was so expensive. The invention cost was around 2.5 billion dollars, with certain firms such as AstraZeneca, Pfizer, and Sanofi spending almost seven billion dollars for every drug they manufacture and market. Mr. Pearson decided to invest in a cheaper drug (Jubila, which counteracts fungus infection), costing thirty-five million dollars. He even opted to buy already manufactured drugs and then sell them at a higher price. This did not go for long before people started asking questions, thus reducing the company’s reputation and overall growth.
b. Invest in Research
The second lesson learned is to put more money into innovation practices. Pearson’s strategy shined when the medicine R&D was at its very worst (Carreyrou, 2019, 15). But in recent years, things turned around for Mr. Pearson. He did not invest in innovative practices, and that resulted in its failure. The only difference between the Valeant Company and Actavis, currently known as Allergan, was that the firm had a growth strategy similar to that of Valeant (Acquisition), but it also concentrated on developing new drugs. This is the reason as to why Actavis managed to purchase Allergan when Valeant could not. Before starting an investment, one should consider the stakeholders and shareholders’ opinions to come up with a perfect decision for the investment.
c. Decision Making can Affect Brand
Poor financial decision-making can reduce brand loyalty, which in turn harms the market valuation of a firm. Wrong decision making will always portray a bad picture to the public hence reducing customer satisfaction. This was evident in Valeant case where the CEO manipulated the investors (“Netflix Dirty Money Series”). To ensure maximum growth and development of the firm, proper financial decision-making is paramount. Similarly, the information given to the media is also important. One should give a piece of clear and correct information to the media when trying to attract investors. This helps to maintain the credibility and reputation of the firm in the market.
d. Mergers could be Sign of Distress
Another lesson learned is that big mergers can be a sign of desperation. The most perplexing story of Valeant is their failure to purchase Actavis Company. Unless a firm is desperate, they do not promise a huge amount of money to buy the opponent company (Carreyrou, 2019, 15). Valeant was able to buy Schering-Plough Company because the firm was deteriorating. Valeant Company made the mistake of showing its state of desperation to the public. This made the public look down upon them, and that is not a good sign for the growth of a business. The Valeant supporters insisted that the effort to purchase Actavis Company was unscrupulous, and Valeant would relinquish any time it fell like. However, Valeant Company had exhausted all its options. That is the reason it decided to go for bigger products such as Sprout pharmaceuticals. The quest for a merger should have been an indication of desperation, but the investors kept purchasing.
e. Capital Budgeting Involves Risks
Finally, several risks and uncertainties are associated with decisions concerning capital budgeting. This was shown in Valeant high-profile acquisitions, which did not go as planned. This is because these decisions are long term decisions (Kengatharan, 2016, 16). The company may expect profits for many years because of that same decision. These expectations may sometimes be wrong. The second reason is due to a substantial investment. Once decisions are taken, it is impossible to reverse them.
7. The Relevance of Behavioral and Emotional Finance
Emotional or behavioral finance is very significant in analyzing both Valeant and Theranos companies. Behavioral finance suggests that psychology and prejudices may affect the financial behavior of finance experts and investors (Tuckett and Taffler, 2008, 5). These two companies collapsed due to the behaviors of their CEOs. The Valeant Company CEO, Pearson, assigned finances to purchase other companies instead of manufacturing and distributing their own drugs. The idea seemed promising since it earned the company huge revenue. But the profits the company was earning did not last long because the CEO raised the drug prices to recover the amount used in purchasing these companies quickly. The idea relates to behavioral finance since it shows how the CEO’s tendencies affected the company. The CEO had a short-term focus, which is a behavioral aspect for quick gratification rather than long-term value. Similarly, the concept of emotional finance was employed in Theranos Company. Its CEO, Elizabeth Holmes, used a huge amount of money to invest in the pharmaceutical industry. She was excited about the revenues or the profits the company would earn. Consequently, her investment focus was emotionally-led (excitement) rather than hard data, which could have informed better decisions. She used stories to lure investors to her company. Her company was rated as one of the best pharmaceuticals in the country. Later it turned out that the company could not deliver what it promised.
Furthermore, the investors in these companies decided to invest in these firms because of the emotional gap. They were excited about the stories the shareholders told them of these companies (Tuckett and Taffler, 2008, 5). They were also anxious and excited about the big returns the market was promising them. This illustrated an emotional aspect since there was no indication that the CEOs followed the capital budgeting process to make decisions. Besides, the exploration of the stock’s bubbles, that is, the rise and fall of the stock price and market value, was very important in describing these firms. The rapid rise and fall of Valeant and Theranos firms’ market valuation were due to emotional response. This could be explained by the investors panicking after realizing that they had made a mistake investing in the two companies. Thus, they withdrew their funds, which resulted in a fall in the valuation of the companies.
8. Conclusion
In a nutshell, financial decision making prior to any investments is very important. An executive has to follow a capital budgeting process to make decisions that build an entity’s sustainability rather than satisfy quick returns. The Valeant and Theranos companies both made improper financial decisions, which led to their collapse. They engaged in unethical practices and used intuitions, poor judgments, and stories to make financial decisions. The key learning from the two companies is that executives must always consider making the right financial decisions to enhance brand loyalty, customer satisfaction and raise the firm reputation. This will also entice new customers to purchase the company’s product. Investors will also be enticed to invest with the company. Consequently, the long-term value should always be a priority for all investment decisions.
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