The most common errors in valuations Company valuation methods. The most common errors in valuations? Pablo Fernandez 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: [email protected] 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. 1 Pablo Fernandez. 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:
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 teacher. 1. Value and price. What purpose does a valuation serve?
Generally speaking, a company’s value is different for different buyers and it may also be different for the buyer and the seller. Value should not be confused with price, which is the quantity agreed between the seller and the buyer in the sale of a company. This difference in a specific company’s value may be due to a multitude of reasons. For example, a large and technologically highly advanced foreign company wishes to buy a well-known national company in order to gain entry into the local market, using the reputation of the local brand. In this case, the foreign buyer will only value the brand but not the plant, machinery, etc. s it has more advanced assets of its own.
For example, if an investor thinks that the future course of GE’s share price will be better than that of Amazon, he may buy GE shares and short-sell Amazon shares. With this position, he will gain provided that GE’s share price does better (rises more or falls less) than that of Amazon. 3. 4. 5. Public offerings: 6. The valuation is used to justify the price at which the shares are offered to the public. The valuation is used to compare the shares’ value with that of the other assets. The valuation of a company or business unit is fundamental for quantifying the value creation attributable to the executives being assessed.
Identification of value drivers: 7. The valuation of a company or business unit is fundamental for identifying and stratifying the main value drivers Strategic decisions on the company’s continued existence: 8. The valuation of a company or business unit is a prior step in the decision to continue in the business, sell, merge, milk, grow or buy other companies. Strategic planning: The valuation of the company and the different business units is fundamental for deciding what products/business lines/countries/customers … to maintain grow or abandon.
The valuation provides a means for measuring the impact of the company’s possible policies and strategies on value creation and destruction. Inheritances and wills: Compensation schemes based on value creation: Valuations of listed companies: There is also the middle position that considers both the buyer’s and seller’s viewpoints and is represented by the figure of the neutral arbitrator. Arbitration is often necessary in litigation, for example, when dividing estates between heirs or deciding divorce settlements. 2 3 Pablo Fernandez. IESE Business School Company valuation methods. The most common errors in valuations . Balance sheet-based methods (shareholders’ equity) These methods seek to determine the company’s value by estimating the value of its assets. These are traditionally used methods that consider that a company’s value lies basically in its balance sheet.
Description In the coming decades, will there be more effective international cooperation to prevent pandemics? The paper must have a clear thesis, stated early. The rest of the paper should contain facts and logic that support the thesis, and should properly cite sources. Analysis of cooperation. Under what conditions do countries cooperate with each other effectively? Analysis of the origins of cooperation. Under what conditions do countries create systems of cooperation?
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