80 Common and Uncommon Errors in Company Valuation

Topics: Net present value, Discounted cash flow, Fundamental analysis Pages: 42 (16091 words) Published: September 19, 2011
80 common and uncommon errors in company valuation

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

1

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

2

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...

References: Brealey, R.A. and S.C. Myers (2000), Principles of Corporate Finance. Sixth edition. McGraw-Hill, New York. Campa, J.M. and P. Fernández (2004), “Are calculated betas good for anything?”, IESE Working Paper. Copeland, T. E., T. Koller, and J. Murrin (2000), Valuation: Measuring and Managing the Value of Companies. Third edition. New York: Wiley. Damodaran, A. (1994), Damodaran on Valuation. New York: John Wiley and Sons . Damodaran, A. (2001), The Dark Side of Valuation . New York: Financial Times-Prentice Hall. Dimoson, E., P. March and M. Staunton (2002), “Global Evidence on the Equity Risk Premium”, Journal of Applied Corporate Finance, September. Durbin, E., and D. Ng (1999), “Uncovering Country Risk in Emerging Market Bond Prices”, Board of Governors of the Federal Reserve System, International Finance Discussion Paper: 639, July. Estrada, J. (2000), “The Cost of Equity in Emerging Markets: A Downside Risk Approach”, Emerging Markets Quarterly, Fall, 19-30. Fernández, P. (2004), “The value of tax shields is NOT equal to the present value of tax shields”, forthcoming in the Journal of Financial Economics . Fernández, P. (2003), “How to value a seasonal company discounting cash flows”, SSRN Working Paper. Fernández, P. (2002), Valuation Methods and Shareholder Value Creation. San Diego, CA: Academic Press. Godfrey, S. and R. Espinosa (1996), “A Practical Approach to Calculating Costs of Equity for Investment in Emerging Markets”, Journal of Applied Corporate Finance, Fall, 80-89. Hamon, J., and B. Jacquillat (1999), “Is there Value-added information in Liquidity and Risk Premiums?”, European Financial Management, November 1999, 5(3), 369-93. Kaminsky, G., and S.L. Schmukler (2002), “Emerging Market Instability: Do Sovereign Ratings Affect Country Risk and Stock Returns?”, Bank Economic Review , 2002, 16(2), 171-95. Knetz, P.J. and M.J. Ready (1997), “On the robustness of the size and book-to-market in crosssectional regressions”, The Journal of Finance, September, 52(4), 1355-1382. Lessard, D. (1996), “Incorporating Country Risk in the Valuation of Offshore Projects”, Journal of Applied Corporate Finance , Fall, 52-63. Mehra, R. (2003), “The equity premium: Why is it a puzzle?”, Financial Analysts Journal, January/February, 54-69. Mehra, R. and E. Prescott (1985), “The equity premium: A puzzle”, Journal of Monetary Economics 15(2), 145-161. Penman, S. H. (2001), Financial Statement Analysis and Security Valuation, New York: McGraw-Hill. Ruback, Richard S. (1986), “Calculating the Market Value of Risk-Free Cash Flows”, Journal of Financial Economics , March, 323-339.
27
80 common and uncommon errors in company valuation
Ruback, R. (1995), “A note on capital cash flow valuation”, Harvard Business School, Case No. 9-295 069. Ruback, R. (2002), “Capital cash flows: a simple approach to valuing risky cash flows”, Financial Management 31, 85-103. Scholes, M. and J.T. Williams (1977), Estimating Betas from Nonsynchronous Data; Journal of Financial Economics , December 1977, 5(3), 309-27. Siegel, Jeremy (1998), Stocks for the Long Run. Second edition. New York : Irwin. Siegel Jeremy J. (1999), “The Shrinking Equity Premium”, Journal of Portfolio Management, Fall, 1017. Stowe, J.D., T.R. Robinson, J.E. Pinto and D.W. McLeavey (2002), Analysis of Equity Investments: Valuation. Baltimore: Association for Investment M anagement and Research. Wang, X. (2000), “Size Effect, Book-to-Market Effect, and Survival”, Journal of Multinational Financial Management, September-December, 10, 257-73.
28
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • Company Valuation Methods. the Most Common Errors in Valuations Essay
  • Company Valuation Essay
  • Common Stock Valuation Essay
  • Valuation Of Common Stock Essay
  • Valuation Essay
  • Valuation Amazon Essay
  • Common Errors Essay
  • Valuation Essay

Become a StudyMode Member

Sign Up - It's Free