Ten mistakes to avoid when valuing a company
Based on our experience, there are a few common mistakes that are made when valuing a company. Controversy still remains in specialised literature around some of these, but there are common themes – we have mapped out the mistakes that most often occur in relation to the Discounted Cash Flow to the Firm (“DCFF”) and Multiples valuation methods. The mistakes presented below only refer to the valuation technique in itself, and do not cover other steps of the valuation process, such as the preparation of financial forecasts and the normalization of the financial performances.
1. Poor assets...
When using the DCFF method and sometimes the Multiples method (depending on the multiple used) we often find that non-operating assets are ignored. Non-operating assets are assets that do not generate any cash flows for the company, such as a building that is neither used nor rented out by the company, or an investment in another company that does not yield any dividends. As these assets do not generate any cash flow for the company, they are not included in its value when calculating the value using these methods. For this reason, the market value of these assets, adjusted for any potential tax impact on their sale, must be added to the valuation result based on the DCFF or Multiples method.
2. The chicken or the egg?
The use of the DCFF method implies the prior determination of a discount rate, which is presumed to reflect, among other things, the financial structure (or gearing) of the company under review.
This discount rate, called WACC, is a weighted average of the cost of equity, i.e. the required return of the shareholders, and the cost of financial debt. A common mistake is to calculate the cost of equity weight on the basis of the book value of the equity instead of its market value. As soon as the market value of the equity is known, the shareholder will then expect a return on that fair value (independently from the book value). A similar mistake consists in calculating the weighted average on the basis of the solvency ratio of the company (i.e. the ratio of shareholders’ equity to the total assets).
However, the correct approach can reach a deadlock, as the equity market value is itself calculated on the basis of the weighted average cost of capital.
Solutions could be to use (i) the iterative option in Excel, (ii) a company target gearing, (iii) a sector gearing or (iv) an equity market value derived from another valuation method.
3. Levered beta: it’s easier!
The discount rate used in the DCFF method is calculated on the basis of various parameters, including the beta. This driver reflects the price sensitivity of a share (or a series of shares in the same sector) with respect to the fluctuations of a market index, and consequently enables the market risk premium to be adjusted to the risk of a specific sector. Conceptually, the beta comprises both an operational and a financial component. It is often assumed that the operational component is taken into account by applying the beta of the sector in which the company to be valued operates or the beta of the peer group formed by similar companies. The financial component is the result of the company gearing, where the risk increases as the amount of debt of the company increases (since debt interests are considered to be a fixed cost).
In contrast to what is sometimes done, the beta must be based on the financial structure of the company to be valued and not on the gearing of companies in the peer group. The starting point is thus the debt-free or “unlevered” beta, which is then converted to a “levered” beta by means of a specific formula.
4. Beta in times of crisis
By definition and by structure, the beta of a given stock market is always equal to 1. In times of crisis, however, not all sectors are affected in the same way. A large number of sectors (such as the TMT sector at the end of the 1990s, or the banking, automobile and aircraft industry in 2008/2009) see their beta increase substantially, while the beta of other less affected sectors fall drastically to such an extent that it no longer mirrors the real industry risk. In such situations, the use of a sector beta observed over a longer period should be preferred to a “spot” beta at the time of valuation.
5. Stupid omissions!
Discounting the future cash flows implies the estimate of these cash flows between the valuation date and infinity. Because this is impossible in practice, this estimate is divided into two phases: (i) the determination of the cash flows over a specific finite future period and (ii) the calculation of a terminal value at the end of this explicit period. Once the terminal value has been calculated, the discounting of this value to the valuation date may be forgotten. The impact of this mistake increases as the length of the explicit period or the discount rate increase. This mistake is obviously independent on the way in which the terminal value is calculated (Gordon-Shapiro model, Multiples method or liquidation value). In addition, particularly with the Gordon-Shapiro model it is also important to take the discount period to the end of the explicit forecast and not one period afterwards, for the discounting of the terminal value.
6. The median? What’s that again?
A common mistake in the application of the Multiples method is to use the average instead of the median of the multiples of the peer group. The median is the middle element in a sorted sample of data. As an illustration, the median of the numbers 3, 30, 2, 1, 4 is 3, while the average is 8 due to the effect of the abnormal figure 30.
The use of the median thus enables extremely low or high values to be disregarded. In practice, abnormally high values are encountered when the financial results (earnings, EBITDA, etc.) of a peer company tend towards zero.
7. Doubled growth
When using the Multiples method, the ratios can be calculated against the last available historic figures (N), as well as against forecasts N+1 or N+2. A mistake is to apply the multiples of the peer group based on year N to the financial parameters of future years of the company to be valued. Indeed, behind each multiple lurk parameters that drive value in a discounted cash flow approach, being mainly the growth of the company and its risk profile. By applying current multiples to future results, the expected growth is taken into account twice.
8. NWC vs. NFD
With the application of multiples to determine the enterprise value (for example EV/EBITDA or EV/EBIT), the company net financial debt (NFD) on the valuation date is deducted to obtain the value of the shares (or equity value). The net financial debt comprises the long and short term interest-bearing debts, less the excess cash. However, the net financial debt can be very volatile and affected both positively or negatively by an unusual level of net working capital (NWC). This unusual level of working capital is regularly not normalised, resulting in the net financial debt often being too high or too low, depending on the stage of the life cycle in which the company finds itself.
9. Illiquidity of the E… quity
The problem that arises here is not unequivocally answered by experts, and it is therefore no surprise to hear that specialised literature leaves this subject untouched. It relates to the illiquidity discount that is applied in the Multiples methods.
We believe that it is incorrect to apply the illiquidity discount to the enterprise value (EV), i.e. before deduction of the net financial debt. The illiquidity reflects the difficulty of finding quickly a buyer for the shares of the company, and in our opinion must consequently be applied to the equity value (and not the enterprise value).
10. NFD… what else?
The tenth and last mistake we would like to highlight is found in both the DCFF and the EV/x multiples methods and consists in omitting the stakeholders who, next to banks, have a right prior to the shareholders, such as parties for whom provisions have been recorded, minorities, holders of stock options, etc. From a technical point of view, these different elements must be deducted from the enterprise value as well (ideally at market value).
The valuation of a company is a complex matter in which a thorough and professional approach is essential. As shown above, limited knowledge on the valuation methods and application in practice can readily lead to mistakes with values being significantly wrong.
Lastly, for all the science, valuation remains an “art” as well which requires careful judgement and experience.