Company Valuation Methods. the Most Common Errors in Valuations

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Pablo Fernández. IESE Business School

Company valuation methods. The most common errors in valuations

Company valuation methods. The most common errors in valuations∗ Pablo Fernández PricewaterhouseCoopers Professor of Corporate Finance IESE Business School Camino del Cerro del Aguila 3. Telephone 34-91-357 08 09. 28023 Madrid, Spain e-mail: fernandezpa@iese.edu

In this paper, we describe the four main groups comprising the most widely used company valuation methods: balance sheet-based methods, income statement-based methods, mixed methods, and cash flow discounting-based methods. The methods that are conceptually “correct” are those based on cash flow discounting. We will briefly comment on other methods since -even though they are conceptually “incorrect”they continue to be used frequently. We also present a real-life example to illustrate the valuation of a company as the sum of the value of different businesses, which is usually called the break-up value. We finish the paper showing the most common errors in valuations: a list that contains the most common errors that the author has detected in the more than one thousand valuations he has had access to in his capacity as business consultant or teacher.

JEL Classification: G12, G31, M21 Keywords: Value, Price, Free cash flow, Equity cash flow, Capital cash flow, Book value, Market value, PER, Goodwill, Required return to equity, Working capital requirements

February 28, 2007

IESE Working Paper No 449 Previous updates: January 2002 and July 2004



Another version of this paper may be found in chapter 2 of the author's bookValuation Methods and Shareholder Value Creation, 2002 Academic Press, San Diego, CA.

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Pablo Fernández. IESE Business School

Company valuation methods. The most common errors in valuations

For anyone involved in the field of corporate finance, understanding the mechanisms of company valuation is an indispensable requisite. This is not only because of the importance of valuation in acquisitions and mergers but also because the process of valuing the company and its business units helps identify sources of economic value creation and destruction within the company. The methods for valuing companies can be classified in six groups:

MAIN VALUATION METHODS BALANCE SHEET Book value Adjusted book value Liquidation value Substantial value INCOME STATEMENT Multiples PER Sales P/EBITDA Other multiples MIXED (GOODWILL) Classic Union of European Accounting Experts Abbreviated income Others

CASH FLOW DISCOUNTING
Equity cash flow Dividends Free cash flow Capital cash flow APV

VALUE CREATION EVA Economic profit Cash value added CFROI

OPTIONS Black and Scholes Investment option Expand the project Delay the investment Alternative uses

In this paper, we will briefly describe the four main groups comprising the most widely used company valuation methods. Each of these groups is discussed in a separate section: balance sheet-based methods (Section 2), income statement-based methods (Section 3), mixed methods (Section 4), and cash flow discounting-based methods (Section 5).1 Section 7 uses a real-life example to illustrate the valuation of a company as the sum of the value of different businesses, which is usually called the break-up value. Section 8 shows the methods most widely used by analysts for different types of industry. The methods that are becoming increasingly popular (and are conceptually “correct”) are those based on cash flow discounting. These methods view the company as a cash flow generator and, therefore, assessable as a financial asset. We will briefly comment on other methods since -even though they are conceptually “incorrect”- they continue to be used frequently. Section 12 contains the most common errors in valuations: a list that contains the most common errors that the author has detected in the more than one thousand valuations he has had access to in his capacity as business consultant or...
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