80 common and uncommon errors in company valuation

Pablo Fernández PricewaterhouseCoopers Professor of Corporate Finance IESE Business School. University of Navarra. Camino del Cerro del Aguila 3. 28023 Madrid, Spain. Telephone 34-91-357 08 09. Fax 34-91-357 29 13. e-mail: fernandezpa@iese.edu

ABSTRACT

This paper contains a collection and classification of 80 errors seen in company valuations performed by financial analysts, investment banks and financial consultants. The author had access to most of the valuations referred to in this paper in his capacity as a consultant in company acquisitions, sales and mergers , and arbitrage processes. Some of the errors are taken from published reports by financial analysts. We classify the errors in six main categories: 1) Errors in the discount rate calculation and concerning the riskiness of the company; 2) Errors when calculating or forecasting the expected cash flows; 3) Errors in the calculation of the residual value; 4) Inconsistencies and conceptual errors; 5) Errors when interpreting the valuation; and 6) Organizational errors.

Keywords: valuation, company valuation, valuation errors JEL Classification: G12 , G31, M21

November 4, 2003

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80 common and uncommon errors in company valuation

This paper contains a classification of the 80 errors providing at least one example of each, taken from actual valuations. The sections of the paper are as follows: 1. Errors in the discount rate calculation and concerning the riskiness of the company 2. Errors when calculating or forecasting the expected cash flows 3. Errors in the calculation of the residual value 4. Inconsistencies and conceptual errors 5. Errors when interpreting the valuation 6. Organizational errors Appendix 1. List of the 80 errors Appendix 2. A valuation containing multiple errors using an ad hoc method Bibliography

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80 common and uncommon errors in company valuation

1. Errors in the discount rate calculation and concerning the riskiness of the company 1.A. Wrong risk-free rate used for the valuation 1. A.1. Using the historical average of the risk-free rate as the actual risk-free rate. Example taken from a financial consultant: “The best estimate of the risk-free rate to use in the CAPM is the historical average of the US risk-free rate from 1928 until today.” This is patently absurd. Any student who used an average historical rate from 1928 to 2001 in a university examination (not to mention in an MBA) would be failed on the spot. The risk-free rate is by definition the rate that can be obtained now (at the time when Ke is calculated) by buying risk-free government bonds now. Expectations and forecasts have little to do with the past, or with an average historical rate. 1. A.2. Using the short-term government bond rate as the meaningful risk-free rate in a valuation. Example taken from a financial consultant: “The best estimate of the risk-free rate to use in the CAPM is the return of 90-day US Treasury Bills.” The correct way to calculate a company’s cost of capital is to use the rate (Yield or IRR) of long-term government bonds (using bonds of similar duration to that of the expected cash flows) at the time of calculating Ke.

1. B . Wrong beta used for the valuation 1. B.1. Use the historical industry beta, or the average of the betas of similar companies, when the result goes against common sense. The example of this error comes from a report written by a financial consulting firm. “The purpose of our study has been to make a professional estimate of the fair value at 31 December 2001 of the shares of INMOSEV, an unlisted real estate firm whose main business consists of buying land and building houses for resale. We have assumed a capital contribution by a third party in the amount of 30 million euros in the year 2002, with an estimated return on its investment of 20%; that is, 6 million euros. “Our study is based...