09 Nov, 2017

# Company Valuation Methods. Most Common Errors in Valuations (Part 8)

**Errors in the discount rate calculation and concerning the company’s riskiness**

1. Wrong risk-free rate used for the valuation

— Using the historical average of the risk-free rate.

— Using the short-term Government rate.

— Wrong calculation of the real risk-free rate.

2. Wrong beta used for the valuation

— Using the historical industry beta, or the average of the betas of similar companies, when the result goes against common sense.

— Using the historical beta of the company when the result goes against common sense.

— Assuming that the beta calculated from historical data captures the country risk.

— Using the wrong formulae for levering and unlevering the beta.

— 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.

— When valuing an acquisition, using the beta of the acquiring company.

3. Wrong market risk premium used for the valuation

— The required market risk premium is equal to the historical equity premium.

— The required market risk premium is equal to zero.

— Assume that the required market risk premium is the expected risk premium.

4. Wrong calculation of WACC

— Wrong definition of WACC.

— The debt to equity ratio used to calculate the WACC is different from the debt to equity ratio resulting from the valuation.

— Using discount rates lower than the risk-free rate.

— Using the statutory tax rate, instead of the effective tax rate of the levered company.

— Valuing all the different businesses of a diversified company using the same WACC (same leverage and same Ke).

— Considering that WACC / (1-T) is a reasonable return for the company’s stakeholders.

— Using the wrong formula for the WACC when the value of debt is not equal to its book value.

— Calculating the WACC assuming a certain capital structure and deducting the outstanding debt from the enterprise value.

— Calculating the WACC using book values of debt and equity.

— Calculating the WACC using strange formulae.

5. Wrong calculation of the value of tax shields

— Discounting the tax shield using the cost of debt or the required return to unlevered equity.

— Odd or ad-hoc formulae.

6. Wrong treatment of country risk

— Not considering the country risk, arguing that it is diversifiable.

— 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.

— Assuming that an agreement with a government agency eliminates country risk.

— Assuming that the beta provided by Market Guide with the Bloomberg adjustment incorporates the illiquidity risk and the small cap premium.

— Odd calculations of the country risk premium.

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

— Including an odd small-cap premium.

— Including an odd illiquidity premium.

— Including a small-cap premium equal for all companies.

**Errors when calculating or forecasting the expected cash flows
**

1. Wrong definition of the cash flows

-Forgetting the increase in Working Capital Requirements when calculating cash flows.

— Considering the increase in the company’s cash position or financial investments as an equity cash flow.

2. Errors in the calculation of the taxes that affect the FCF.

— Expected Equity Cash Flows are not equal to expected dividends plus other payments to shareholders (share repurchases…)

— Considering net income as a cash flow.

— Considering net income plus depreciation as a cash flow.

3. Errors when valuing seasonal companies

— Wrong treatment of seasonal working capital requirements.

— Wrong treatment of stocks that are cash equivalent.

— Wrong treatment of seasonal debt.

4. Errors due to not projecting the balance sheets

— Forgetting balance sheet accounts that affect the cash flows.

— Considering an asset revaluation as a cash flow.

— Interest expenses not equal to D Kd.

5. Exaggerated optimism when forecasting cash flows

**Errors in the calculation of the residual value
**

— Inconsistent cash flow used to calculate perpetuity.

— The debt to equity ratio used to calculate the WACC to discount the perpetuity is different from the debt to equity ratio resulting from the valuation.

— Using ad hoc formulas that have no economic meaning.

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

— Calculating the residual value using the wrong formula.

— Assume that a perpetuity starts a year before it really starts.

**Inconsistencies and conceptual errors
**

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

— Considering the cash in the company as an equity cash flow when the company has no plans to distribute it.

— Using real cash flows and nominal discount rates, or vice-versa.

— The free cash flow and the equity cash flow do not satisfy ECF = FCF + ΔD — Int (1-T).

2. Errors when using multiples

— Using the average of multiples extracted from transactions executed over a very long period of time.

— Using the average of transactions multiples that have a wide scatter.

— Using multiples in a way that is different to their definition.

— Using a multiple from an extraordinary transaction.

— Using ad hoc valuation multiples that conflict with common sense.

— Using multiples without using common sense.

3. Time inconsistencies

— Assuming that the equity value will be constant for the next five years.

— The equity value or the enterprise value does not satisfy the time consistency formulae.

4. Other conceptual errors

— Not considering cash flows resulting from future investments.

— Considering that a change in economic conditions invalidates signed contracts.

— Considering that the value of debt is equal to its book value when they are different.

— Not using the correct formulae when the value of debt is not equal to its book value.

— Including the value of real options that have no economic meaning.

— Forgetting to include the value of non-operating assets.

— Inconsistencies between discount rates and expected inflation.

— Valuing a holding company assuming permanent losses (without tax savings) in some companies and permanent profits in others.

-Wrong concept of the optimal capital structure.

— In mature companies, assuming projected cash flows that are much higher than historical cash flows without any good reason.

— Assumptions about future sales, margins, etc. that are inconsistent with the economic environment, the industry outlook, or competitive analysis.

— Considering that the ROE is the return to the shareholders.

— Considering that the ROA is the return of the debt and equityholders.

— Using different and inconsistent discount rates for cash flows of different years or for different components of the free cash flow.

— Using past market returns as a proxy for required return to equity.

— Adding the liquidation value and the present value of cash flows.

— Using ad hoc formulas to value intangibles.

— Arguing that different discounted cash flow methods provide different valuations.

— Wrong notion of the meaning of the efficient markets.

— Applying a discount when valuing diversified companies.

— Wrong arbitrage arguments.

— Adding a control premium when it is not appropriate.

**Errors when interpreting the valuation
**

— Confusing Value with Price.

— Asserting «the valuation is a scientific fact, not an opinion».

— A valuation is valid for everybody.

— A company has the same value for all buyers.

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

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

— Forgetting that a valuation is contingent on a set of expectations about cash flows that will be generated and about their riskiness.

— Affirming «a valuation is the starting point of a negotiation».

— Affirming «a valuation is 50% art and 50% science».

**Organizational errors
**

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

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

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

Other parts of the article «Company Valuation Methods» (Part 1), (Part 2), (Part 3), (Part 4), (Part 5), (Part 6), (Part 7)

Read also: DD Check List, Mandate F. A. Q.