Common Errors In Company Valuation

Posted on 20/01/2011

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The following is a list of common corporate valuation and investment errors identified by Pablo Fernandez (University of Navarra – IESE Business School) in a paper entitled “80 Common Errors in Company Valuation“.

1. Errors in the discount rate calculation and concerning the riskiness of the company

A. Wrong risk -free rate used for the valuation

1. Using the historical average of the risk-free rate.
2. Using the short-term Government rate.

B. Wrong beta used for the valuation

1. Using the historical industry beta, or the average of the betas of similar companies, when the result goes against common sense.
2. Using the historical beta of the company when the result goes against common sense
3. Assuming that the beta calculated from historical data captures the country risk.
4. Using the wrong formulae for levering and unlevering the beta.
5. Arguing that the best estimation of the beta of a company from an emerging market is the beta of the company with respect to the S&P 500.
6. When valuing an acquisition, using the beta of the acquiring company.

C. Wrong market risk premium used for the valuation

1. The required market risk premium is equal to the historical equity premium.
2. The required market risk premium is equal to zero.

D. Wrong calculation of WACC

1. Wrong definition of WACC.
2. Debt to equity ratio used to calculate the WACC is different than the debt to equity ratio resulting from the valuation.
3. Using discount rates lower than the risk free rate.
4. Using the statutory tax rate, instead of the effective tax rate of the levered company.
5. Valuing all the different businesses of a diversified company using the same WACC (same leverage and same Ke).
6. Considering that WACC / (1-T) is a reasonable return for the stakeholders of the company.
7. Using the wrong formula for the WACC when the value of debt is not equal to its book value.
8. Calculating the WACC assuming a certain capital structure and deducting the outstanding debt from the enterprise value.
9. Calculating the WACC using book values of debt and equity.

E. Wrong calculation of the value of tax shields

1. Discounting the tax shield using the cost of debt or the required return to unlevered equity.
2. Odd or ad-hoc formulae.

F. Wrong treatment of country risk

1. Not considering the country risk, arguing that it is diversifiable.
2. Assuming that a disaster in an emerging market will increase the beta of the country’s companies calculated with respect to the S&P 500.
3. Assuming that an agreement with a government agency eliminates country risk.
4. Assuming that the beta provided by Market Guide with the Bloomberg adjustment incorporates the illiquidity risk and the smallcap premium.

G. Including an illiquidity, small-cap, or specific premium when it is not appropriate

2. Errors when calculating or forecasting the expected cash flows

A. Wrong definition of the cash flows

1. Forget ting the increase in Working Capital Requirements when calculating Cash Flows.
2. Considering the increase in the company’s cash position or financial investments as an equity cash flow.
3. Errors in the calculation of the taxes that affect the FCF.
4. Expected Equity Cash Flows are not equal to expected dividends plus other payments to shareholders (share repurchases, …)
5. Considering net income as a cash flow.
6. Considering net income plus depreciation as a cash flow.

B. Errors when valuing seasonal companies

1. Wrong treatment of seasonal working capital requirements.
2. Wrong treatment of stocks that are cash equivalent.
3. Wrong tre atment of seasonal debt.

C. Errors due to not projecting the balance sheets

1. Forgetting balance sheet accounts that affect the cash flows.
2. Considering an asset revaluation as a cash flow.
3. Interest expenses not equal to D Kd.

D. Exaggerated optimism when forecasting cash flows.

3. Errors in the calculation of the residual value

A. Inconsistent Cash Flow used to calculate perpetuity.

B. Debt to equity ratio used to calculate the WACC to discount the perpetuity is different to the Debt to equity ratio resulting from the valuation.

C. Using ad hoc formulas that have no economic meaning.

D. Using arithmetic averages instead of geometric averages to assess growth.

E. Calculating the residual value using the wrong formula.

4. Inconsistencies and conceptual errors

A. Conceptual errors about the free cash flow and the equity cash flow

1. Considering the cash in the company as an equity cash flow when the company has no plans to distribute it.
2. Using real cash flows and nominal discount rates or viceversa.
3. The free cash flow and the equity cash flow do not satsify ECF = FCF + ?D – Int (1-T).

B. Errors when using multiples

1. Using the average of multiples extracted from transactions executed over a very long period of time.
2. Using the average of transactions multiples that have a wide dispersion.
3. Using multiples in a way that is different to their definition.
4. Using a multiple from an extraordinary transaction.
5. Using ad hoc valuation multiples that conflict with common sense.

C. Time inconsistencies

1. Assuming that the equity value will be constant for the next five years.
2. The Equity value or the Enterprise value do not satisfy the time consistency formulae.

D. Other conceptual errors

1. Not considering cash flows resulting from future investments.
2. Considering that a change in economic conditions invalidates signed contracts.
3. Considering that the value of debt is equal to its book value when they are different.
4. Not using the correct formulae when the value of debt is not equal to its book value.
5. Including the value of real options that have no economic meaning.
6. Forgetting to include the value of non-operating assets.
7. Inconsistencies between discount rates and expected inflation.
8. Valuing a holding company assuming permanent losses (without tax savings) in some companies and permanent profits in others.
9. Wrong concept of the optimal capital structure.
10. In mature companies, assuming projected cash flows that are much higher than historical cash flows without any good reason.
11. Assumptions about future sales, margins, etc. that are inconsistent with the economic environment, the industry outlook, or competitive analysis.
12. Considering that the ROE is the return to the shareholders.
13. Considering that the ROA is the return of the debt and equityholders.
14. Using different and inconsistent discount rates for cash flows of different years or for different components of the Free cash
flow.
15. Using past market returns as a proxy for required return to equity.
16. Adding the liquidation value and the present value of cash flows.
17. Using ad hoc formulas to value intangibles .
18. Arguing that different discounted cash flow methods provide different valuations.

5. Errors when interpreting the valuation

A. Confusing Value with Price.

B. Asserting that “ the valuation is a scientific fact, not an opinion. ”

C. A valuation is valid for everybody.

D. A company has the same value for all buyers.

E. Confusing strategic value for a buyer with fair market value.

F. Considering that the goodwill includes the brand value and the intellectual capital.

G. Forget ting that a valuation is contingent on a set of expectations about cash flows that will be generated and about their riskiness.

6. Organizational errors

A. Making a valuation without checking the forecasts made by the client.

B. Commissioning a valuation from an investment bank without having any involvement in it.

C. Involving only the finance department in valuing a target company.

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