119 common errors in company valuations

by Pablo Fernandez and Andrada Bilan
Download as PDF IESE Business School, University of Navarra, Madrid, Spain

Excerpts
This document contains a collection and classification of 119 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, mergers, and arbitrage processes.

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;
6) Organizational errors.

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. B. Wrong beta used for the valuation.
1. C. Wrongmarket risk premium used for the valuation.
1. D. Wrong calculation of WACC.
1. E. Wrong calculation of the value of tax shields.
1. F. Wrong treatment of country risk.
1.G. Including an illiquidity, small-cap,or specific premium when it is not appropriate

2. Errors when calculating or forecasting the expected cash flows
2. A. Wrong definition of the cash flows.
2. B. Errors when valuing seasonal companies.
2. C. Errors due to not projecting the balance sheets.
2. D. Exaggerated optimism when forecasting the cash flows.

3. Errors in the calculation of the residual value
3. A. Inconsistent cash flow used to calculate the value of a perpetuity.
3. B. The debt to equity rati used to calculate the WACC for discounting the perpetuity is different than the debt to equity ratio resulting from the valuation.
3. C. Using ad hoc formulas that have no economic meaning.
3. D. Using arithmetic averages instead of geometric averages to assess growth. 3. E. Calculating the residual value using the wrong formula.
3. F. Assume that a perpetuity starts a year before it really starts

4. Inconsistencies and conceptual errors
4.A. Conceptual errors about the free cash flow and the equity cash flow.
4.B. Errors when using multiples.
4.C. Time inconsistencies.
4.D. Other conceptual errors

5. Errors when interpreting the valuation
Confusing Value with Price.
Asserting that a valuation is "a scientific fact, not an opinion."
Considering that the goodwill includes the brand value and the intellectual capital...

6. Organizational errors
6. A. Valuation without any check of the forecasts provided by the client.
6. B. Commissioning a valuation from an investment bank and not having any involvement in it.
6. C. Involving only the finance department in valuing a target company.
6. D. Assigning the valuation of a company to an auditor.

Appendix 1. List of errors.
Appendix 2. A valuation with multiple errors of an ad hoc method

Full paper available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1025424
For direct link to PDF, click here.

Reproduced on www.reportwatch.net by kind permission of the author, and made available thanks to the Social Science Research Network (http://papers.ssrn.com/).
Spanish version: http://ssrn.com/abstract=962921

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