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09 Nov, 2017

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

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.

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