The most common errors in valuations

by Pablo Fernandez
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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 flowdiscounting-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.

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:
  • BALANCE SHEET
  • INCOME STATEMENT
  • MIXED (GOODWILL)
  • CASH FLOW
  • DISCOUNTING
  • VALUE CREATION
  • OPTIONS

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).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 basedon 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.

Full paper available at: http://ssrn.com/abstract=274973
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/).
Other papers on valuation by Pablo Fernandez: http://ssrn.com/author=12696

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