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».
— 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.
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