Pablo Fernández 80 Common Errors in Company Valuation IESE Business School

Pablo Fernández 80 common errors in company valuation
IESE Business School
80 common 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: company valuation, valuation errors, valuation
JEL Classification: G12, G31, M21
June 26, 2004
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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 f ollows:
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
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 essentially on information provided to us by INMOSEV, consisting of
historical data and assumptions and hypotheses about estimated future income over the next 11 years.
Table 1 shows the equity cash flows that have been used in this study. The main assumptions
and estimates made in applying the valuation method mentioned above are as follows:
Growth rate of the equity cash flows after 2012 = 1%.
Discount rate. The cost of equity corresponds to the return on long-term risk-free assets, plus the
market risk premium, multiplied by a coefficient called beta
Return on Spanish 15 -year government bonds (risk-free return) = 5.00%
Market risk premium = 4.50% (Source: BNP Paribas, SCH)
Unlevered beta (ßu) = 0.27. Average of the unlevered betas of listed companies in Spain (see Table 2)
Levered beta (ßL) according to INMOSEV’s (average) capital structure = 0.50
2
The average cost of equity is 7.25%.

Consequently, the value of INMOSEV’s shares at 31 December 2001 is on the order of approximately
143.09 million euros.”
Table 1. Main magnitudes of the INMOSEV valuation

Equity cash flow (ECF)ßu Ku ßL Ke Present value of ECF
2001 0 0.27 6.22% 0
2002 -30,000 0.27 6.22% 0.45 7.04% -28,026
2003 0 0.27 6.22% 0.42 6.91% 0
2004 0 0.27 6.22% 0.5 7.26% 0
2005 0 0.27 6.22% 0.52 7.35% 0
2006 0 0.27 6.22% 0.53 7.37% 0
2007 0 0.27 6.22% 0.57 7.55% 0
2008 5,631 0.27 6.22% 0.59 7.67% 3,437
2009 6,401 0.27 6.22% 0.56 7.54% 3,633
2010 7,184 0.27 6.22% 0.54 7.43% 3,796
2011 7,963 0.27 6.22% 0.52 7.32% 3,920
2012 20,501 0.27 6.22% 0.49 7.23% 9,412
Present value of cash flows from 2013 onward 152,913
Sum 149,085
From this total we must deduct the margin that the new shareholder who contributes the 30 million euros will
earn on the deal (we estimate a figure of around 6 million).
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Table 2. Betas of listed real estate firms in Spain . Source: SCH.
Vallehermoso Colonial Metrovacesa Bami Urbis average
Levered beta 0.49 0.12 0.38 0.67 0.42 0.42
Unlevered beta 0.29 0.11 0.27 0.39 0.28 0.27
Error. The resulting unlevered beta (0.27) is so small that it makes no sense to use it to value any
company, let alone an unlisted one. Also, these betas (and any others that might have been used) are
arbitrary, as Table 3 shows. If we calculate the betas of the five companies on 31 December 2001
using daily and monthly data and different periods, we can obtain average unlevered betas ranging
anywhere from 0.22 to 0.85. Obviously, a valuation that depends on such a shifting and unreliable
variable is contrary to all common sense and prudence.
Table 3. Betas calculated at December 31, 2001, with respect to the Madrid Stock Exchange
General Index, using daily and monthly data for different periods prior to 31/12/2001
Beta at 31/12/2001
Period Data Vallehermoso Colonial Metrovacesa Bami Urbis Average
Daily 0.70 0.46 0.67 0.58 0.60
5 years Monthly 0.71 0.45 1.25 1.00 0.85
Daily 0.67 0.41 0.63 0.59 0.58
4 years Monthly 0.58 0.43 0.95 0.80 0.69
Daily 0.60 0.31 0.51 0.48 0.48
3 years monthly 0.41 0.17 0.59 0.42 0.40
Daily 0.42 0.15 0.19 0.27 0.25 0.26
2 years Monthly 0.68 0.28 0.50 0.85 0.67 0.60
Daily 0.37 0.18 0.18 0.19 0.27 0.24
1 year Monthly 0.59 0.41 0.46 0.32 0.78 0.51
Daily 0.31 0.23 0.22 0.09 0.25 0.22
6 months Monthly 0.81 0.72 0.68 0.39 0.80 0.68
Maximum 0.81 0.72 0.68 1.25 1.00 0.85
Minimum 0.31 0.15 0.17 0.09 0.25 0.22
3
In the end, the shares were sold for 70.4 million euros (instead of 143 million). This is the figure
obtained by discounting the flows shown in Table 1 at 9.8% (rather t han at 7.26%).
1. B.2 . Us ing the historical beta of the company when the result goes against common sense. Historical
betas change dramatically, as is shown in Campa and Fernández (2004). These authors calculate the
betas of 3,813 companies on each day of December 2001 and January 2002, using 60 monthly returns,
and report that the maximum beta of a company was, on the average, 15.7 times its minimum beta.
The median of the maximum beta divided by the minimum beta was 3.07. The median of the
percentage daily change (in absolute value) of the betas was 20%, and the median of the percentage (in
absolute value) of the betas was 43%. Table 3 of this paper and Damodaran (2001, page 72) also show
that the calculated betas change dramatically and depend very much on the period used to estimate
the m.
1. B.3. Assuming that the beta calculated from historical data captures the country risk. Interpretation
of the beta of a foreign company listed on the stock market in the USA, t aken from an investment
bank: “The question is: Does the beta calculated on the basis of the company’s share price in New
York capture the different premiums for each risk? Our answer is yes, because just as the beta captures
changes in the economy and the effect of leverage, it must necessarily absorb the country risk.”
There are various ways of including a company’s country risk component in the CAPM formula. The
most common is to use the spread between the long-term dollar treasury bonds of the country in which
the firm operates and long-term U.S. Treasury bonds.
1. B.4. U sing the wrong formulae to lever and unlever the beta. Fernández (2002, page 506) shows
six different formulae for levering and unlevering the beta. Only two of them are correct, as shown in
Fernández (2004b):
• If the company expects to increase its debt, the correct relationship between the levered beta
(ßL ) and the unlevered beta (ßu) is: ßL = ßu + (ßu – ßd) D (1 – T) / E. See Fernández (2004a).
• If the company will not increase its debt, the correct relationship between the levered beta
(ßL ) and the unlevered beta (ßu) is: ßL = ßu + (ßu – ßd) (D – VTS) / E. See Myers (1974):
Other wrong relationships are:
Damodaran (1994): ßL = ßu + ßu D (1 – T) / E
Practitioners: ßL = ßu + ßu D / E
Harris -Pringle (1985), Ruback (1995 and 2002): ßL = ßu + (ßu – ßd) D / E.
Miles-Ezzell (1980): ßL = ßu + (ßu – ßd) (D / E) [1 – T Kd / (1+Kd)]
1. B.5. Arguing that the best estimation of the beta of an emerging market company is the company’s
beta with respect to the S&P 500. “The best way to estimate the beta of an emerging economy
company with a U.S. stock market listing is through a regression of the return of the share on the
return of a U.S. stock market index.”
No, because it is well known (we have plenty of data to confirm this) that companies that are rarely
traded have absurdly low calculated betas. Scholes and Williams (1977), for example, warned of this
problem and suggested a method for partly getting around it.
There is also the problem of the instability of betas that have been estimated by regression: they are
very unstable and depend very much on the data used to calculate them.
Simply using a share’s historical beta without analyzing the share and the company’s future prospects
is very risky, as historical betas are unstable and depend, in almost all companies, on what data we use
(daily, weekly, monthly...).
1. B.6. When valuing an acquisition, us ing the beta of the acquiring company. From an analyst’s
report: “As the target company is much smaller than the bidder, the Target Company will have almost
no influence on the resulting capital structure and the riskiness of the resulting company. Therefore,
the relevant beta and the relevant capital structure for the valuation of the Target Company are those of
the acquiring company.” Wrong, the relevant risk is the risk of the acquired assets. If this were not the
case, a Government bond would have a different value for every company.
1. C. Wrong market risk premium used for the valuation
1. C.1. The required market risk premium is equal to the historical equity risk premium. Table 4 shows
that the historical U.S. equity risk premium changes considerably depending on the interval used to
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calculate it. The required market risk premium (the one used in valuation to determine the required
return to equity) is an expectation and has little to do with history.
Table 4. Historical equity risk premium in the U.S .

Average Annual Returns of Equity Risk Premium
Arithmetic Average Stocks T-Bills T-Bonds Stocks – T -Bills Stocks – T -Bonds
1928-1953 9.46% 1.03% 2.96% 8.44% 6.51%
1928-1999 12.68% 3.92% 5.05% 8.76% 7.63%
1928-2002 11.60% 3.93% 5.35% 7.67% 6.25%
1962-2002 11.19% 6.03% 7.53% 5.17% 3.66%
1992-2002 10.73% 4.40% 8.58% 6.32% 2.15%
Average Annual Returns of Risk Premium

Geometric Average Stocks T-Bills T-Bonds Stocks – T -Bills Stocks – T -Bonds
1928-1953 6.49% 1.02% 2.92% 5.47% 3.57%
1928-1999 10.76% 3.87% 4.79% 6.89% 5.96%
1928-2002 9.62% 3.89% 5.09% 5.73% 4.53%
1962-2002 9.90% 5.99% 7.14% 3.90% 2.76%
1992-2002 9.09% 4.40% 8.14% 4.69% 0.95%
1. C.2. The required market risk premium is equal to zero. This argument typically follows the
arguments of Mehra and Prescott (1985) and Mehra (2003) , who say that “stocks and bonds pay off in
approximately the same states of nature or economic scenarios, and hence, they should command
approximately the same rate of return.” Siegel (1998 and 1999) interprets Table 4 by saying: “although
it may seem that stocks have more risk than long-term Treasury bonds, this is not true. The safest long-
term investment (from the viewpoint of preserving the investor’s purchasing power) has been stocks,
not Treasury bonds.”
1. D. Wrong calculation of WACC
1. D.1. Wrong definition of WACC. An example:

Valuation, dated April 2001, of an edible oil company in Ukraine, provided by a leading
European investment bank. “The weighted average cost of capital (WACC) is defined as:
WACC = Rf + ßu (Rm – Rf), (1)
where: Rf = risk-free rate; ßu = unlevered beta; Rm = market risk rate.”
The WACC calculated for the Ukrainian company was 14.6% and the expected free cash flows (in real
terms, which means, excluding inflation) for the Ukrainian company were:
(Million euros) 2001 2002 2003 2004 2005 2006 2007 2008 2009
FCF 3.7 14.7 11.9 -3.0 12.9 12.9 12.6 12.6 12.6
The reported enterprise value in December 2000 was 71 million euros. This result comes
from adding the present value of the 2001-2009 FCFs (45.6) discounted at the 14.6% plus the present
value of the residual value calculated with the FCF of 2009 assuming no growth (25.3).
In fact, (1) is not at all the definition of the WACC. It is the definition of the required return to assets,
also known as the cost of unlevered equity (Ku). We also must interpret the term (Rm – Rf) as the
expected risk premium.
The correct formula for the WACC is:
WACC = [D / (D+E)] Kd (1– T) + [E / (D+E)] Ke (2)
where: Ke = Ku + (D / E) (1-T) (Ku - Kd) (3)
Kd = Cost of debt. D = Value of debt. E = Value of equity. T = effective corporate tax rate
The valuation of the Ukrainian company used a (wrongly defined) “WACC” of 14.6%. But
14.6% was the Ku, not the WACC. The 71 million euros was the value of the unlevered equity, not the
enterprise value.
5
On December 2000, the Ukrainian company ’s debt was 33.7 million euros and the nominal
cost of debt was 6.49%. The correct WACC for the Ukrainian company should have been1:
Ke = Ku + (D / E) (1-T) (Ku - Kd)= 14.6 + (33.7/48.63) (1-0.3)(14.6-6.49) = 18.53%
WACC = [D / (D+E)] Kd (1– T) + [E / (D+E)] Ke = 0.409 x 6.49 (1-0.30) + 0.591 x 18.53 = 12.81%
Enterprise value = E+D = PV(FCF;12.81%) = 82.33 million euros
1. D.2. The debt to equity ratio used to calculate the WACC is different than the debt to equity ratio
resulting from the valuation.
An example is the valuation of a broadcasting company performed by an investment bank
(see T able 5), which discounted the expected FCFs at the WACC (10%) and assumed a constant
growth of 2% after 2008. The valuation provided lines 1 to 7, and stated that the WACC was
calculated assuming a constant Ke of 13.3% (line 5) and a constant Kd of 9% (line 6). The WACC was
calculated using market values (the equity market value on the valuation date was 1,490 million and
the debt value 1,184 million) and the statutory corporate tax rate of 35%.
The valuation also included the equity value at the end of 2002 (3,033; line 8) and the debt
value at the end of 2002 (1,184; line 10). Table 6 provides the main results of the valuation according
to the investment bank.
Errors
a. Wrong calculation of the WACC. To calculate the WACC, we need to know the evolution of the
equity value and the debt value. We calculate the equity value based on the equity value provided for
2002. The formula that relates the equity value in one year to the equity value in the previous year is
E t = Et- 1 (1+Ket ) - ECFt.
To calculate the debt value, we may use the formula for the increase of debt, shown in line 9. The
increase of debt may be calculated if we know the ECF, the FCF, the interest and the effective tax rate.
Given line 9, it is easy to fill line 10.
Line 11 shows the debt ratio according to the valuation, which decreases with time.
If we calculate the WACC using lines 4, 5, 6, 8 and 10, we get line 12. The calculated WACC is
higher than the WACC assumed and used by the valuer.
Another way of showing the inconsistency of the WACC is to calculate the implicit Ke in a WACC of
10% using lines 4, 6, 8 and 10. This is shown in line 13. If we are using a WACC of 10%, Ke should
be much lower than 13.3%.
b. The capital structure of 2008 is not valid for calculating the residual value because in order to
calculate the present value of the FCF growing at 2% using a single rate, a constant debt to equity ratio
is needed.
Table 5. Valuation of a broadcasting company performed by an investment bank

Data provided by the investment bank in italics
2002 2003 2004 2005 2006 2007 2008
1 FCF -290 -102 250 354 459 496
2 ECF 0 0 0 0 34 35
3 Interest expenses 107 142 164 157 139 112
4 Effective tax rate 0.0% 0.0% 0.0% 0.0% 12.0% 35.0%
5 Ke 13.3% 13.3% 13.3% 13.3% 13.3% 13.3%
6 Kd 9.0% 9.0% 9.0% 9.0% 9.0% 9.0%
7 WACC used in the valuation 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
8 Equity value (E) 3,033 3,436 3,893 4,410 4,997 5,627 6,341
9 ?D = ECF - FCF + Int (1-T ) 397 244 -86 -197 -303 -389
10 Debt value (D) 1,184 1,581 1,825 1,739 1,542 1,239 850
11 D/(D+E) 28.1% 31.5% 31.9% 28.3% 23.6% 18.0% 11.8%
12 WACC using lines 4,5,6,8,10 12.09% 11.95% 11.93% 12.08% 12.03% 11.96%
13 Implicit Ke in a WACC of 10% 10.39% 10.46% 10.47% 10.39% 10.64% 10.91%
1
The (D/E) ratios must be calculated using the values obtained in the valuation.
6
Table 6. Valuation using the wrong WACC of 10%

Present value in 2002 using a WACC of 10%
Present value in 2002 of the free cash flows 2003-2008 647
Present value in 2002 of the residual value (g=2%) 3,570
Sum 4,217
Minus debt -1,184
Equity value 3,033
To perform a correct valuation, assuming a constant WACC from 2009 on, we must
recalculate Table 5. Tables 7 and 8 contain the valuation correcting the WACC. To assume a constant
WACC from 2009 on, the debt must also increase by 2% per year (see line 9, 2009). This implies that
the ECF (line 2) in 2009 is much higher than the ECF in 2008.
Simply by correcting the error in the WACC, the equity value is reduced from 3,033 to 2,014
(a 33.6% reduction).
Table 7. Valuation calculating the WACC correctly

2002 2003 2004 2005 2006 2007 2008 2009
1 FCF -290 -102 250 354 459 496 505.9
2 ECF 0 0 0 0 34 35 473.2
3 Interest expenses 107 142 164 157 139 112 76.5
4 Effective tax rate 0.0% 0.0% 0.0% 0.0% 12.0% 35.0% 35.0%
5 Ke 13.3% 13.3% 13.3% 13.3% 13.3% 13.3% 13.3%
6 Kd 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0%
8 Equity value (E) 2,014 2,282 2,586 2,930 3,320 3,727 4,187 4,271
9 ?D = ECF - FCF + Int (1-T ) 397 244 -86 -197 -303 -389 17
10 Debt value (D) 1,184 1,581 1,825 1,739 1,542 1,239 850 867
11 D/(D+E) 37.0% 40.9% 41.4% 37.2% 31.7% 25.0% 16.9% 16.9%
12 WACC calculated with 4,5,6,8,10 11.71% 11.54% 11.52% 11.70% 11.59% 11.44% 12.04%
Table 8. Valuation using the corrected WACC from Table 6

Present value in 2002 using the WACC calculated in T able 6
Present value in 2002 of the free cash flows 2003-2008 588
Present value in 2002 of the residual value (g=2%) 2,610
Sum 3,198
Minus debt -1,184
Equity value 2,014
1. D.3. Using discount rates lower than the risk-free rate. An example is error 3 in Appendix 2. Ke and
Ku are always higher than the risk-free rate. WACC may be lower than the risk-free rate only for
investments with extremely low risk. An example of that may be found in Ruback (1986).
1. D.4 . Using the statutory tax rate, instead of the effective tax rate of the levered company. There are
many valuations in which the tax rate used to calculate the WACC is the statutory tax rate (normally
arguing that the correct tax rate is the marginal tax rate). However this is wrong. The correct tax rate to
use for calculating the WACC for valuing a company is the effective tax rate of the levered company
in every year.
1. D.5. Valuing all the different businesses of a diversified company using the same WACC (same
leverage and same Ke).
1. D.6. Considering that WACC / (1-T) is a reasonable return for the company’s stakeholders. Some
countries as sume that a reasonable return a telephone company’s assets is WACC / (1-T). Obviously,
this is not correct. It could only be valid for no n-growing perpetuities and if the return on assets was
calculated before taxes.
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1. D.7 . U sing the wrong formula for the WACC when the value of debt (D) is not equal to its book
value (N). Fernández (2002, page 416) shows that the expression for the WACC when the value of
debt (D) is not equal to its book value (N) is WACC = (E Ke + D Kd – N r T) / (E + D). Kd is the
required return to debt and r is the cost of debt.
1. D.8 . Calculat ing the WACC assuming a capital structure and deducting the current debt from the
enterprise value. This error appears in a valuation by an investment bank. Current debt was 125,
enterprise value was 2180, and the debt to equity ratio used to calculate the WACC was 50%.
This is wrong because the outstanding and forecasted debt should be used to calculate the WACC. The
equity value of a firm is given by the difference between the firm value and the outstanding debt,
where the firm value is calculated using the WACC, and the WACC is calculated using the
outstanding (market value of) debt. Alternatively, if the firm starts with its current debt and moves
towards another round of financing, then a variable WACC (different for each year) should be used,
and the current debt should be deducted from the enterprise value.
1. D.9 . Calculat ing the WACC using book values of debt and equity. This is quite a common error.
The appropriate values of debt and equity are the ones resulting from the valuation.
1. E. Wrong calculation of the value of tax shields
1. E.1 . Discounting the tax shield using the required return to unlevered equity. Many valuers assume,
following Ruback (1995 and 2002), that the value of tax shields (VTS) is the present value of tax
shields (D Kd T) discounted at the required return to unlevered equity (Ku). Fernández (2004a and
2004 b) proves that this expression is incorrect and that the value of tax shields is the present value of
D Ku T discounted at the required return to unlevered equity (Ku): VTS = PV[D Ku T; Ku]
1.E.2. Odd or ad-hoc formulae. Fernández (2002, page 506) shows different expressions for
calculating the value of tax shields that are frequently used and that are supported by some papers in
the financial literature. Only two of them are correct, as shown in Fernández (2004b):
• If the company expects to increase its debt, the value of tax shields is the present value of D Ku
T discounted at the required return to unlevered equity (Ku): VTS = PV[D Ku T; Ku]. See
Fernández (2004a).
• If the company will not increase its debt, the value of tax shields is : PV[D T Kd; Kd]. See
Myers (1974).
Some incorrect formulae for calculating the value of tax shields are:
Harris -Pringle (1985) and Ruback (1995, 2002): PV[Ku; D T Kd ]
Damodaran (1994): PV[Ku; DTKu - D (Kd- R F) (1 -T)]
Practitioners: PV[Ku; DTKd - D(Kd- R F)]
Miles-Ezzell (1980): PV[Ku; D T Kd] (1+Ku)/ (1+Kd)
1. F. Wrong treatment of country risk
1. F.1. Not considering the country risk, arguing that it is diversifiable. Example taken from a
regulat or: “It is not correct to include the country risk of an emerging country because from the
perspective of global investors only systematic risk matters, and country -specific events will be
uncorrelated with global market movements. Therefore, country-specific events will be unsystematic
risk, totally uncorrelated with global market movements.” According to this view, the required return
to equity will be the same for a US diversified portfolio as for a Bolivian diversified portfolio.
1. F.2. Assuming that a disaster in an emerging market will increase the calculated beta, in relation to
the S&P 500, of the country’s companies. Example taken from a financial consulting firm: “The
occurrence of any dramatic systemic event (devaluation, end of convertibility, capital transfer controls,
threats to democratic stability) that significantly raises the country risk will lead automatically to a
substantial increase in the estimated beta, in relation to the S&P500, of the companies that operate in
that country.”
No. That is why, when valuing companies in emerging countries, we use the country risk, because the
beta no longer captures all the above-mentioned risks: devaluation, end of convertibility, capital
transfer controls, threats to democratic stability...
8
Also, if ADRs have low liquidity (if they are traded only a few times each day and are unlikely to be
traded exactly at the close of each session, which is when analysts usually take prices for calculating
betas), then the calculated beta will tend towards zero, owing to the non-synchronous trading effect,
which is perfectly described by Scholes and Williams (1977).
1. F.3. Assuming that an agreement with a government agency eliminates country risk. Example taken
from an investment bank: “If a government grants a company a monopoly of a particular market, with
agreements that guarantee legal and tax stability and economic equilibrium, then there is no country
risk (such as devaluation, end of convertibility, capital transfer controls, threats to democratic
stability).”
No. The risks of devaluation, end of convertibility, capital transfer controls, threats to democratic
stability, etc. remain. No government can eliminate its own risk. That is to say, the shares of a
company that operates in a country cannot have less risk than the government bonds of that country. A
company’s shares would have exactly the same risk as the country’s government bonds only if the
government were to guarantee and fix future dividends for shareholders. However, that does not
usually happen.
1. F.4. Assume that the beta provided by Market Guide with the Bloomberg adjustment incorporates
the illiquidity risk and the small cap premium. Example taken from an investment bank: “The Market
Guide beta captures the distorting effects of the share’s low liquidity and the small size of the firm
through the so-called Bloomberg adjustment formula.”
No. The so-called “Bloomberg adjustment formula” is simply an arbitrary adjustment to make the
calculated betas converge towards 1. The arbitrary adjustment consists of multiplying the calculated
beta by 0.67 and adding 0.33. Adj. Beta = 0.67 * raw beta + 0.33. It must be stressed that this
adjustment is completely arbitrary.
1. G. Including an illiquidity, small-cap, or specific premium when it is not appropriate.

Examples are errors 1 and 2 in section 12.
2. A. Wrong definition of the cash flows
2. A.1. Forgetting the increase of working capital requirements when calculating cash flows. An
example is error 1 in Appendix 2 .
2. A.2. Considering an increase in the company’s cash position or financial investments as an equity
cash flow. Examples of this error may be found in many valuations; and also in Damodaran (2001,
page 211), who argues that “when valuing a firm, you should add the value of cash balances and near-
cash investments to the value of operating assets.” In several valuations of Internet companies, the
analysts calculate the present values of expected cash flows and add the company ’s cash, even though
it is well known that the company is not going to distribute it in the foreseeable future.
It is wrong to add all the cash because:
1. The company needs some cash to continue its operations, and
2. The company is not expected to distribute the cash immediately
It will be correct to add the cash only if:
- The interest received on the cash were equal to the interest paid on the debt, or
- The cash is due be distributed immediately, or
- The cost of debt used to calculate the WACC was the weighted average of the cost of debt and the
interest received on the cash holdings. In this case, the debt used to calculate the debt to equity ratio
must be debt minus cash. Increases in cash must then be included in “Investments in working capital.”
The value of the excess cash (cash above and beyond the minimum cash needed to continue
operations) is lower than its book value if the interest received on the cash is lower than the interest
pai d on the debt. The company increases its value by distributing excess cash to the shareholders or
by using it to reduce its debt, rather than keeping it.
9
2. A.3. Errors in the calculation of the taxes that affect the FCF. Using the taxes paid (in $ amount) by
the levered company. Some valuers use the statutory tax rate, or a tax rate other than the tax rate of
the levered company , to calculate the FCF. Fernández (2002, page 501) claims that the correct tax
rate for calculating the FCF is the tax rate of the levered company.
2. A.4. Expected equity cash flows are not equal to expected dividends plus other payments to
shareholders (share repurchases…). In several valuation reports, the valuer computes the present
value of positive equity cash flows in years when the company will not distribute anything to
shareholders. Also, Stowe, Robinson, Pinto, and McLeavey (2002) say that “Generally, Equity Cash
Flow and dividends will differ. Equity Cash Flow recognizes value as the cash flow available to
stockholders even if it is not paid out.” Obviously, that is not correct, unless we assume that the
amounts not paid out are reinvested and obtain a return equal to Ke (the required return to equity).
2. A.5. Considering net income as a cash flow. Fernández (2002, page 178) points out that net income
is equal to the equity cash flow only in a no-growth perpetuity (a constant P&L and constant balance
sheet company).
2. A.6. Considering net income plus depreciation as a cash flow. Example taken from a valuation
performed by an institution: “The sum of the net income plus depreciation is the rent (cash flow)
generated by the company.” Then, the valuer concluded that the equity value was the net present value
of this “rent”.
2. B . Errors when valuing seasonal companies
2. B.1. Wrong treatment of seasonal working capital requirements. Fernández (2003) provides a
valuation of a company in which the seasonality is due to purchases of raw materials: the equity value
of this company calculated using annual data without making the necessary adjustments understates
the true value by 45% if the valuation is done at the end of December, and overstates the true value by
38% if the valuation is done at the end of November. The error due to adjusting only by using average
debt and average working capital requirements ranges from –17.9% to 8.5%.
2. B.2. Wrong treatment of inventories that are cash equivalents. Fernández (2003) shows that when
inventories are a liquid commodity such as grain or seeds, it is not correct to consider all of them as
working capital requirements. Excess inventories financed with debt are equivalent to a set of futures
contracts: not considering them as such leads us to undervalue the company.
2. B.3. Wrong treatment of seasonal debt. Fernández (2003) shows that the error due to using annual
data instead of monthly data when there is seasonal debt is enormous. It also shows that adjusting by
using average debt reduces the error, but the error is still considerable.
2. C. Errors due to not projecting the balance sheets
2. C.1. Forgetting balance sheet accounts that affect the cash flows. In a balance sheet,
WCR + NFA = D + Ebv,
where WCR = Working Capital Requirements; NFA = Net Fixed Assets; D = Book value of debt;
Ebv = Book value of equity. It also holds that
?WCR + ?NFA = ?D + ?Ebv.
Many valuations are wrong because the valuer did not project the balance sheets, and the increase in
assets (?WCR + ?NFA, which appear in the cash flow calculation) does not match the assumed
increase in debt plus the assumed increase in the book value of equity.
2. C.2. Considering an asset revaluation as a cash flow. In countries with high inflation, companies
are permitted to revalue their fixed assets (and their net worth). But this is merely an accounting
appreciation, not a cash outflow (although the fixed assets increase) nor a cash inflow (although the
net worth increases).
2. C.3. Interest payments are not equal to debt times cost of debt. In several valuations, this simple
relationship did not hold.
10
2. D. Exaggerated optimism when forecasting the cash flows. Two examples are error 5 in
Appendix 2 and the following lines extracted from a valuation report about Enron Corp., produced by
a recognized investment bank on July 12, 2001, when the share price was $49.
“We view Enron as one of the best companies in the economy. There are still several
misconceptions about Enron that mask the company’s strong fundamentals. We therefore hosted an
investor conference call on June 27 to clarify Enron’s growth prospects and answer investors’
questions.
“We expect Enron shares to rebound sharply in the coming months. We believe that Enron
shares have found their lows and will recover significantly as investor confidence in the company
returns and as misconceptions about Enron dissipate. We strongly reiterate our Buy rating on the stock
with a $68 price target over the next 12 months.
“Enron is a world-class company, in our view. We view Enron as one of the best companies
in the economy, let alone among our group of diversified natural gas companies. We are confident in
the company’s ability to grow earnings 25% annually for the next five to ten years, despite its already
large base. We believe that Enron investors have the unique opportunity to invest in a high growth
company with improving fundamentals.
“We strongly reiterate our Buy rating on the stock with a $68 price target over the next 12
months.
Enron earning model, 1994-2005E. US$ millions except per- share data
1994 1995 1996 1997 1998 1999 2000 2001E 2002E 2003E 2004E 2005E
Net income 438 504 568 88 686 827 896 1,563 1,939 2,536 3,348 4,376
Adjusted EPS 0.83 0.91 0.91 0.87 1.00 1.18 1.47 1.85 2.25 2.75 3.52 4.47
Dividends per share 0.38 0.41 0.43 0.46 0.48 0.50 0.50 0.50 0.50 0.50 0.50 0.50
Book value per share 5.15 5.65 6.64 9.27 9.95 12.28 13.94 15.47 17.99 21.02 24.79 29.47
“We recently raised our 2001 EPS estimate $0.05 to $1.85 and established a well-above-
consensus 2002 estimate of $2.25. We are confident in the company’s ability to grow earnings 25%
annually for the next five to ten years, despite its already large base.”
It is well known what happened to Enron’s share price after the date of this report.
3. A. Inconsistent cash flow used to calculate the value of a perpetuity. An example is the valuation of
a manufacturing company performed by a financial consulting firm (see Table 9), which shows a
valuation performed by discounting expected free cash flows at the WACC rate of 12%. Lines 1 to 5
contain the calculation of the free cash flows. NOPAT (Net Operating Profit after Taxes) does not
include interest expenses. The residual value in 2007 is calculated assuming a residual growth of 2.5%:
Residual value in 2007 = 12,699 = 1,177 x 1.025 / (0.12 - 0.025).
Table 9. Valuation of a manu facturing company performed by a financial consulting firm

line $million 2003 2004 2005 2006 2007
1 Net Operating Profit After Taxes 500 522 533 574 616
2 Depreciation 1,125 1,197 1,270 1,306 1,342
3 Capital expenditures -1,445 -722 -722 -361 -361
4 Investment in working capital 203 -450 -314 -399 -420
5 Free cash flow 383 547 767 1,120 1,177
6 Residual value in 2007 (WACC 12% and residual growth 2.5%) 12,699
Present value in 2002 of free cash flows (WACC =12%)

7 2003-2007 2,704
8 Residual value in 2007 7,206
9 Total EV (Enterprise Value) 9,909
10 Plus cash 280
11 Minus debt -3,628
12 Equity value 6,561
11
The enterprise value (line 9) is the sum of the present value of the free cash flows 2003-2007
(line 7) plus the present value of the terminal value (line 8). Adding cash (line 10) and subtracting debt
value (line 11), the financial consulting firm calculates the equity value (line 12) as $6.561 million. It
sounds all right, but the valuation contains two errors.
Errors
1. It is inconsistent to use the FCF of 2007 to calculate the residual value. The reason for this is that in
2007 the forecasted capital expenditures (361) are smaller than the forecasted depreciation (1342). It is
wrong to assume that this will happen in the future indefinitely: net fixed assets would be negative in
2010!
The normative 2007 FCF used to calculate the residual value should be $196 million
(assuming capital expenditures equal to depreciation) or less (if we assume that the net fixed assets
also grow at 2.5%). Correcting this error in the valuation, Table 3 shows that the equity value is
reduced to $556 million (instead of $6,561 million).
Table 10. Valuation of the manufacturing company in Table 9 adjusting the no rmative free cash
flow and the residual value
Normative 2007 FCF 196
6 Residual value in 2007 2,115 =196 x 1.025 / (0.12 - 0.025)
Present value in 2002 of free cash flows:
7 2003-2007 2,704
8 Residual value in 2007 1,200
9 Total EV (Enterprise Value) 3,904
10 Plus cash 280
11 Minus debt -3,628
12 Equity value 556
Of course, in a given year or in several years, capital expenditures may be lower than depreciation,
but it is not consistent to take this as the normative cash flow for calculat ing the residual value as a
growing perpetuity.
3. B. The debt to equity ratio used to calculate the WACC for discounting the perpetuity is different
than the debt to equity ratio resulting from the valuation. This error is commonly made in many
valuations and is also found in the valuation in section 1.D.2.
3. C. U sing ad hoc formulas that have no economic meaning. An example is error 4 in Appendix 2.
3. D. U sing arithmetic averages instead of geometric averages to assess growth. An example is given
in Table 11, which shows the past evolution of the EBITDA of a manufacturing company operating in
a mature industry. The investment bank that performed the valuation used this table as a justification
for a forecasted average annual increase of EBITDA of 6%. It is obvious that the geometric average is
a much better indicator of average growth in the past.
Table 11. Arithmetic vs. geometric growth

1995 1996 1997 1998 1999 2000 2001 2002
EBITDA 127 132 149 91 150 132 146 147
Annual growth 3.9% 12.9% -38.9% 64.8% -12.0% 10.6% 0.7%
Arithmetic average 1995-2002 6.0%
Geometric average 1995-2002 2.1%
3. E. Calculating t he residual value using the wrong formula. When the residual value is calculated as
a growing perpetuity, the correct formula is RVt = CFt+1 / (K – g). RVt is the residual value in year t.
12
CFt+1 is the cash flow of the following year. K is the appropriate discount rate, and g is the expected
growth of the cash flows. But many valuations use the following incorrect formulae:
RVt = CFt / (K – g).
RVt = CF t+1 (1+g) / (K – g).
4. A. Conceptual errors about the free cash flow and the equity cash flow
4. A.1. Considering the cash in the company as an equity cash flow when the company is not going to
distribute it. An example of this was given in section 1.
4. A.2 . Using real cash flows and nominal discount rates , or viceversa. An example is the valuation in
section 1.D.1. , which also has another error: the projected FCF are given in real terms, that is,
excluding inflation (which is why free cash flows are constant from 2007-2009), while Ku (14.6%) is
calculated in nominal terms, that is, including inflation.
For a correct valuation, the cash flows and the discount rate used must be consist ent. This means that:
• Cash flows in real terms must be discounted with real discount rates, and
• Cash flows in nominal terms must be discounted with nominal discount rates.
The correct way is either to increase cash flows by inflation or to deduct inflation from nominal
discount rates. In fact, for real (constant) cash flows, such as those used in this valuation, we must use
real WACC and real Ku:
Real WACC = (1+Nominal WACC) /(1+ expected inflation) - 1
Real Ku = (1+Nominal Ku) /(1+ expected inflation) - 1
4. A.3 . The free cash flow and the equity cas h flow do not satisfy ECF = FCF + ?D – Int (1-T). This
equation represents the relationship between the equity cash flow and the free cash flow. It may be
found in Fernández (2002, pages 42 and 401). In many valuation reports, given the FCF, the debt
increase (?D), the interest payments (Int), and the effective tax rate (T), the calculated ECF bears no
relation at all to the company’s expected equity cash flows (dividends plus share repurchases).
4. B . Errors when using multiples
4. B.1. Using the average of multiples extracted from transactions executed over a very long period of
time.
An investment bank produced this valuation in January 2003. “Table 12 shows the multiples
of recent transactions. We use the median of these multiples (6.8), as the median eliminates extremes.”
Table 12. Transaction multiples in the oil business

Acquirer/Target Date EV/EBITDA EV/EBIT
Bunge/Cereol November 2002 6.3x 9.6x
Cargill/Cerestar October 2001 12.1x na
Land O’Lakes/Purina Mills June 2001 4.0x 8.2x
Primor Inversiones/Mavesa January 2001 7.5x 10.3x
Corn Product International/Arcancia CPC October 1998 7.3x na
Eridania Béghin-Say/American Maize products February 1995 5.5x 8.3x
Average 7.1x 9.1x
Median 6.8x 9.0x
Errors
1. The multiples come from a very long period of time: from February 1995 to November 2002.
2. Dispersion of the multiples. The EV/EBITDA ranges between 4 and 12.1. Why should 6.8 (the
median) be a reasonable multiple?
13
4. B.2 . Using the average of transactions multiples that have a wide dispersion. An example is Table
12.
4. B.3. U sing multiples in a way that is inconsistent with their definition. An example is Table 13,
which shows a valuation performed by a well known investment bank using the price-earnings ratio.
Table 13. Valuation using the price-earnings ratio.

1 Expected net income of next year 28.6 $ millions
Valuation using PER Minimum Maximum
2 Assumed PER 9.0 10.0
3 PER x net income 257.4 286.0
4 Plus: excess cash 93.1 93.1
5 Minus: Financial debt 115.6 115.6
6 Minus: Retirement commitments 34.5 34.5
7 Equity value 200.4 229.0
Error. The Price-earnings ratio is equal to the equity value divided by net income. It is not correct to
deduct the debt (line 5). The correct equity value (according to the assumptions) should be 115.6
million higher than line 7. A dding the excess cash (line 4) is correct in this case because the buyer
planned to distribute the excess cash immediately to the shareholders.
4. B.4 . U sing a multiple from an extraordinary transaction. An example is the following valuation
performed by a consulting firm for an arbitrage.
Table 14 shows the balance sheet s and P&L of Telecosin.
Table 14. Balance sheets and P&L of Telecosin, 1995-2000 (thousand euros)
(Thousand euros) 1995 1996 1997 1998 1999 2000
Sales 336 768 1,009 1,848 2,746 6,815
Net income 15 8 11 98 156 87
Dividends 0 0 0 0 0 0
Cash and banks 33 13 53 426 421 82

Accounts receivable 119 201 211 635 779 3,372
Inventories 0 73 20 42 150 141
Net fixed assets 59 53 50 158 235 804
TOTAL ASSETS 212 340 334 1,261 1,586 4,400
Short-term financial debt 0 0 2 2 0 1,124

Trade creditors 100 233 102 212 204 1,619
Other creditors 47 36 146 340 558 798
Long-term bank debt 0 0 0 405 367 314
Shareholders’ equity 64 72 83 301 457 545
TOTAL LIABILITIES 212 340 334 1,261 1,586 4,400
Employees at 31 December 11 15 21 41 51 101
“The legitimacy of the comparable transactions method is based on the fact that financial
analysts working for merchant banks, consulting firms and financial companies for valuing companies
like Telecosin widely and predominantly use this method and the revenue parameter.
“In September last year a group of investors consisting of Dresdner Kleinwort Benson, MCH
and Sibec acquired 20% of the company IP Systems for 3.6 million euros. This implies that 100% of
the company was valued at 18 million euros.
“IP Systems has many features in common with Telecosin, making it a suitable point of
comparison for determining the value of Telecosin. There are, however, two differences in Telecosin’s
favor that need to be mentioned: long experience in the market (which implies more consolidated
14
goodwill and greater recognition by customers), and a significantly larger workforce. The following
table offers a comparison of the two companies:
IP SYSTEMS Telecosin
Turnover 99 0.9 million euros (1 month) 2.75 million euros
Turnover 2000 10.4 million euros 6.81 million euros
Workforce 63 people 110 people
Founded in 1999 1994
In 1999 IP Systems had a turnover of 0.9 million euros. However, the company had only
started trading in November. If we extrapolate this turnover to the year as a whole, we get an annual
turnover of 5.4 million. Therefore, the growth in IP System’s turnover in the period 1999-2000 is 90%,
lower than that of Telecosin in the same period (146%).
The IP Systems investors valued the company with reference to the sales figure for the
current year (2000), using a sales multiple of 1.7. If this same multiple (1.7) is applied to Telecosin’s
minimum forecasted sales for 2001 (16.8 million euros), the value of the shares of the company in
December 2000 is 28.6 million.
Decision of the Court of Arbitration

“A party has presented a valuation based on what is known as the comparable transactions
method. Some securities firms and investment banks used this method for a period of approximately
two years (between 1998 and 2000). There was a clear reason for using it: it was impossible to explain
the exorbitant prices paid for many new economy firms using the methods in general use up until then.
The comparable transactions method never had any theoretical underpinnings. And certainly, after the
summer or autumn of 2000 it was totally discredited. This method is therefore not worth considering.
“We are left, therefore, with the discounted cash flow method, which is the most widely
accepted method of firm valuation, and the one that the Panel of Arbitrators considers most
appropriate in this case. We value the shares of Telecosin at 2.4 million euros.”
4. B.5 . Using ad hoc valuation multiples that conflict with common sense. An example is the valuation
of Terra’s shares performed by a Euro-American bank in April 2000 (see Table 15), when Terra’s
share price was 73.8 euros. As the valuation given by Table 15 is 104 euros per share, the bank advised
its customers to buy Terra shares.
The valuation is based on the 15 largest Internet companies in the U.S.A. The first column
gives the price per share, the second column the number of shares outstanding, and the third column
the companies’ capitalization in million dollars. When the net debt is added to the capitalization, what
the bank calls enterprise value (EV) is obtained. Thus, the sum of the enterprise values of the 15
largest Internet companies in USA was 278.145 billion dollars. The Euro American bank’s analyst
then divided this quantity by the number of inhabitants in the U.S., which he estimated to be 273
million, obtaining the EV per capita in the U.S.: 1,019 dollars.
At the bottom of Table 15, the analyst divided Terra’s market into 3 geographical areas:
Spain, Hispanic America (U.S. citizens who are Spanish speakers) and Latin America. Column [1]
shows the gross national product per capita in each of the three geographical areas, and column [2]
shows the percentage they represent with respect to the gross national product per capita in USA
($32,328). Column [3] is the result obtained by multiplying the EV per capita in the U.S. (1,019
dollars) by the ratio between the gross national product per capita in each of the three geographical
areas and the U.S. gross national product per capita (column [2]). He then multiplied column [3] by the
number of inhabitants in each geographical area (column [4]) and by Terra’s estimated market share in
each of these markets (column [5]), to obtain Terra’s value in each of these geographical areas
(column [6]). Adding the three amounts in column [6], he arrived at the value for Terra: 27.117 billion
dollars. After subtracting the net debt from this amount, he obtained Terra’s implicit capitalization:
27.642 billion dollars. By dividing this quantity by the number of Terra shares (280 million) and by the
euro exchange rate, the analyst obtained the value of the Terra share: 104 euros per share.
Doesn’t this valuation seem surprising to the reader? We suggest another way of getting the
figure of 104 dollars per share: The value of the Terra share is twice the age of Manolo Gómez’s
mother-in-law, who is 52. We chose Manolo because he lives near Terra’s corporate headquarters. Of
15
course, this valuation is absurd, but it has as much rigor as that given in Table 15. As the saying goes,
“the blind man dreamt he saw, and he dreamt what he wanted to see”. 2
Terra traded at 11 euros at the end of 2000, at 9 euros at the end of 2001, and was trading
between 4 and 5.4 euros in the first six months of 2003.
Table 15. Valuation of Terra performed by a Euro-American bank on 7 April 2000

Price per Million shares Capitalization Net debt EV (enterprise
share ($) ($ million) value)
AOL 65.0 2,282 148,315 -1,472 146,843
Yahoo! 158.0 526 83,184 -1,208 81,976
Lycos 61,5 110 6,760 -618 6,142
Excite@Home 30,0 352 10,559 302 10,861
Go Networks 19,0 165 3,133 349 3,482
NBC Interactive 38,5 32 1,223 259 1,482
About.com 65,0 17 1,075 -176 899
The Go2Net 71,4 31 2,182 214 2,396
Ask Jeeves 59,0 35 2,062 -166 1,896
LookSmart 38,0 88 3,340 -97 3,243
Juno 13,8 39 531 -89 442
Infospace 65,5 217 14,186 -89 14,097
GoTo.com 43,0 49 2,107 -104 2,003
Earthink 18,0 138 2,489 -206 2,283
TheGlobe.com 5,0 30 152 -52 100
Sum of the 15 largest information hubs in USA 281,298 -3,153 278,145
No. inhabitants (million) 273

EV per capita (US$) 1,019
GNP per capita in the US (US$) 32,328
GNP per GNP per capita Adjusted EV per Million Terra market Value
capita (US$) vs. USA (%) capita (US$) inhabitants share (%)
[1] [2] [3] [4] [5] [6]
Spain 17,207 53% 542 39 30% 6,345
Hispanic America 16,164 50% 509 30 5% 764
Latin America 7,513 23% 237 338 25% 20,008
Average 9,080 28% 286 407 23%
Value of Terra ($ million) 27,117
Net debt ($ million) -525
Implicit capitalization ($ million) 27,642
Million shares: 280 Dollar/euro exchange rate: 0.94875 Price per share (euros) 104
4. C. Time inconsistencies
4. C.1. Assume that the equity value will be constant in the future. Example taken from an analyst’s
valuation report: “As we do not know the evolution of the equity value of the company, a good
approximation is to assume that the equity value will remain constant in the following five years.”
That is not correct. Fernández (2002, pages 401 and 497) shows that the relationship between the
equity value of different years is: Et = Et-1 (1+Ket) – ECFt. Note that the equity value is constant (Et =
E t-1) only if ECFt = E t-1 K et . That only happens in no-growth perpetuities.
4. C.2. The Equity value or the Enterprise Value does not satisfy the time consistency formulae.
Fernández (2002, page 401) shows that the relationship between the enterprise value of different
years is: Et+Dt = (E t-1+D t-1) (1+WACCt) – FCFt.
2
Other valuations of Internet companies using esoteric multiples may be seen in Fernández (2002),
chapter 12.
16
4. D. Other conceptual errors
4. D.1 . Not considering cash flows resulting from future investments. Oleina Holding, a leading edible
oil company in the Ukraine, with strong volume and brand recognition also in Russia. The company
was operating almost at full capacity and had plans to invest in a new plant in Russia.
Example taken from an investment bank: “From a methodological viewpoint, if this project had to be
taken into account, its net present value should be assumed to be nil. The most reasonable approach
would be to assume that the investment is expected to deliver a return that is equal to financial market
expectations, which implies a net present value equal to zero.”
Example taken from a business school professor, acting as expert witness in an arbitrage : “By taking
into account a future Russian plant project in the valuation, the seller of the shares would benefit from
the profits generated by this new project without incurring the related risks, as he would anyway not
take part in the future investment.”
4. D.2. Considering that a change in economic conditions invalidates signed contracts. A European
bank bought a securities company on February 16, 2001. The European bank bought 80% of the shares
and gave the current owners a put on the remaining 20% of the shares with an exercise price of 54
million euros (same per share price as the transaction). The current owners tried to exercise the put in
May 2002, but the European bank refused, arguing that: “As, due to specific extraordinary
circumstances, the situation of the financial markets and of the world economy in May 2002 was very
much worse than on 16 February 2001, we have no obligation to accept the exercise of the put at the
agreed exercise price. The unforeseen recession was aggravated by the shock of 11 September 2001,
which had both short and medium-term effects, insofar as stock market behavior over the following
twelve months was unfavorable and highly volatile. ” The European bank had a new valuation of the
shares of the securities company on May 2002 that argued that the price of the shares that fallen 86.3%
since February 2001.
Contracts are signed to be fulfilled. On top of that, there are no grounds for the claim that
stock market volatility increased significantly after 11 September 2001. By March 2002 the volatility
of the main American indexes was similar to what it had been before September 11. Cons equently, the
effect of September 11 did not cause a permanent increase in volatility.
The effect of September 11 on prices was also short-lived. Table 16 shows what a short time
the effect of September 11 on the S&P 500, the NASDAQ and other world stock market indexes
lasted. It is quite clear that the effect of September 11 did not lead to a permanent increase in volatility
or a permanent decrease in prices. Consequently, it cannot be true to say that the market risk has
increased as a result of September 11.
Table 16. Effect of September 11, 2001 on four stock indexes: S&P 500, NASDAQ , EURO
STOXX 50, and FTSE 100. Source: Thomson Financial DataStream.
S&P 500 NASDAQ EURO FTSE 100
STOXX 50
10/09/01 1092.5 1695.4 3440.7 5033.7
11/09/01 1092.5 1695.4 3220.3 4746.0 September 11, 2001
12/09/01 1092.5 1695.4 3260.9 4882.1
13/09/01 1092.5 1695.4 3293.8 4943.6
14/09/01 1092.5 1695.4 3091.2 4755.8
17/09/01 1038.8 1579.6 3205.0 4898.9
18/09/01 1032.7 1555.1 3189.9 4848.7
19/09/01 1016.1 1527.8 3105.1 4721.7
20/09/01 984.5 1470.9 2967.9 4556.9
21/09/01 965.8 1423.2 2877.7 4433.7 Lowest level after September 11
10/10/01 1081.0 1626.3 3468.3 5153.1 Eurostoxx higher than on September 10
11/10/01 1097.4 1701.5 3510.6 5164.9 FTSE 100 higher than on September 10
15/10/01 1090.0 1696.3 3393.6 5067.3 NASDAQ higher than on September 10
16/10/01 1097.5 1722.1 3455.3 5082.6 S&P 500 higher than on September 10
26/10/01 1104.6 1769.0 3611.9 5188.7
17
4. D.3. Considering that the value of debt is equal to its book value, when they are different. A
common assumption in valuations is to consider that the value of debt (D) is equal to its book value
(N). However, there are circumstances in which this assumption is not reasonable. For example, if a
company has long-term fixed rate debt and interest rates have increased (decreased), the debt value (D)
will be lower (higher) than its book value (N).
4. D.4. Not using the correct formulae when the value of debt (D) is not equal to its book value (N).
Fernández (2002, page 416) shows that the expression for the WACC, when the value of debt (D) is
not equal to its book value (N), is WACC = (E Ke + D Kd – N r T) / (E + D). Kd is the required return
to debt and r is the cost of debt.
4. D.5. Including the value of real options that have no economic meaning. An example: Table 17
contains the net present value calculation of a project for a new plant in Brazil for a supplier of
automotive interior systems to most of the major car assemblers. Initial outlays amounted to nearly
$38 million. The project involved supplying components for 500,000 cars the first year and 850,000
cars the following years. The net present value of the project (given the cost of the new plant and the
expected free cash flows), using a WACC of 14.95%, is negative: -$ 7.98 million.
Table 17. Net present value calculation of a project for a new plant in Brazil. WACC = 14.95%
($ million) in nominal terms 0 1 2 3 4 5 Salvage value
FCF -37.9 3.5 12.6 10.7 8.5 7.1 3.8
NPV -7.98
However, the valuer argued that the owner of the plant had additional options that were not included
in the net present value calculation:
- Options that came from obtaining further supply contracts in the future during the life of the plant
(growth options, valued as three European options with strike prices of $5.6, $0.4 and $0.085
million).
- Option to renew initial supply contracts at their expiration date (prolongation option, valued as a
European option with strike price of $42.7 million). The salvage value of the project was neither the
value of its contract renewal nor the liquidation price of its assets, but the higher of the two.
- Flexibility options: possibility of adapting project costs to the evolution of sales.
- Abandonment option: possibility of abandoning the investment prior to the end of its life (valued as
an American put option on the future cash flows stream with strike price equal to its salvage value
and maturity equal to the project’s life).
Valuing the options and the project together, the valuer said that the expanded net present value
(value of the plant taking into consideration the real options embedded in the investment) was as
shown in T able 18. The valuer concluded: “Considering the real options together displays a
significant positive expanded NPV for different assumptions about the future evolution of the state
variable (number of cars produced and assembled in Brazil), and therefore validates the optimality of
the investment decision. ”
Table 18. Expanded net present value of a project for a new plant in Brazil, as a function of the drift
rate and of the volatility
Drift rate
Volatility 0% 7% 15%
7% 2.4 7.5 15.2
13% 2.5 7.6 15.2
20% 2.8 7.2 13.6
Volatility is the standard deviation of the number of cars that are produced and assembled in Brazil.
Drift rate means the expected growth of the number of cars that are produced and assembled in Brazil.
Questions to the reader: Do the options belong to the company? Do you think that the specification
of the options (which depend almost exclusively on the number of cars produced and assembled in
Brazil) is a good description of them? Would you advise the company to invest in the project?
4. D.6. Forget ting to include the value of non-operating assets. Example taken from a valuation
report: “We do not consider in our valuation the value of the shares that the company has in a traded
telephone company because this investment is totally unrelated to the company’s industrial and
commercial activities.” The value of a company’s shares is the present value of the expected equity
cash flows plus the current value of the non-operating assets.
18
4. D.7. Inconsistencies between discount rates and expected inflation. In a valuation report, the
WACC (in nominal terms) used was 5.4% and the expected inflation rate used to forecast the free
cash flows was 6%.
4. D.8. Valuing a holding company assuming permanent losses (without tax savings) in some
companies and permanent profits in others. In a valuation report performed by an investment bank of
a holding company that had two subsidiaries, the equity value of one subsidiary was put at $81
million, and the equity value of the other, at -$33.9. The taxes of the latter were forecasted as zero
because the company was assumed to have permanent losses.
4. D.9. Wrong concept of the optimal capital structure. Example taken from a valuation report: “The
optimal capital structure is that that maximizes the enterprise value (debt value plus equity value). In
the context of the Adjusted Present Value, the enterprise value is equal to the value of the unlevered
company plus the present value of tax shields. Since the value of the unlevered company is constant
and unrelated to leverage, the optimal capital structure is the one that maximizes the present value of
tax shields.” More about the optimal capital structure may be found in chapter 18 of Fernández
(2002).
4. D.10. In mature companies, assuming projected cash flows that are much higher than historical
cash flows without any good reason. An example is error 5 in Appendix 2.
4. D.11. Assumptions about future sales, margins, etc. that are inconsistent with the economic
environment, the industry outlook, or competitive analysis. Example taken from a valuation
performed by a financial consultant of a platform company: “The following table presents the two
extreme scenarios of the evolution of the sales of the company.
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Optimistic 2.7 3.5 4.2 5.1 6.2 7.4 9.0 10.5 12.1 13.6 15.0
Pessimistic 2.7 3.4 4.1 4.9 5.7 6.8 8.0 9.2 10.5 11.6 12.5
The expected inflation is 2%.”
4. D.12. Consider ing that the ROE is the return to shareholders in non-traded companies. This is a
fairly common and quite mistaken assumption. If ROE is a good approximation of the return to the
shareholders of non-traded companies, it should be also a good approximation for traded companies.
The following table shows that the ROE of General Electric has little to do with the return to its
shareholders.
General Electric 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 average
Shareholder return 14% 26% 1% 44% 40% 51% 42% 53% -5% -15% -37% 16%
ROE 21% 18% 18% 23% 24% 25% 25% 26% 27% 27% 26% 24%
4. D.13. Considering that the ROA is the return of the debt and equityholders. Following the same
argument as in the previous point, the ROA has little to do with the return to the shareholders. The
ROA (NOPAT / (Ebv +D)) is an accounting ratio, while return is something that refers mainly to
changes in expectations.
4. D.14. Us ing different and inconsistent discount rates for cash flows of different years or for
different components of the free cash flow. An example is error 2 in Appendix 2.
4. D.15. Using past market returns as a proxy for required return to equity. Example taken from a
valuation performed by an institution: “The opportunity cost of investing in the company could be the
return of an investment in the stock exchange. As an indicator of the return of the stock exchange, we
use the S&P 500 index, but with a long time series to eliminate the influence of short-term market
movements. S&P 500 as of June 28, 1999 = 1331.35. S&P 500 as of December 28, 2002 = 1457.66.
(1457.66 / 1331.35) – 1 = 9.5% .
Therefore, the estimated annual cost of equity is: (1 + 9.5%)2 – 1 = 19.9%.”
19
4. D.16. Adding the liquidation value and the present value of cash flows. Example taken from a
valuation performed by an institution: “The minimum value of the shares of the company is $20.1
million, the sum of the liquidation value ($9.6 million) and the present value of expected cash flows
($10.5 million).”
4. D.17. Using ad hoc formulas to value intangibles. Example taken from a valuation performed by a
financial consultant: “Valuing intangibles is very difficult. But one approximation would be to
quantify the guarantees that the shareholders have given to the banks. The company’s financial debt is
about $20 million. We estimate that the bank loans without the shareholders’ guarantees could have
an additional annual cost of 2.5%. Quantifying this 2.5% along 10 years, the additional financial cost
will be about $2 million. Therefore, $2 million is a good approximation of the value of the
intangibles.”
4. D.18. Argu ing that different discounted cash flow methods provide different valuations. All
methods always give the same value, as is shown in chapters 17 and 21 of Fernández (2002). This
result is logical, since all the methods analyze the same reality under the same hypotheses; they differ
only in the cash flows taken as the starting point for the valuation.
5. Errors when interpreting the valuation. The following errors arise from forgetting that the value
resulting from any valuation is always contingent on a set of expectations (about the future of the
company, the industry, the country, and the world economy) and on an assessment of the risk of the
company.
5. A. Confusing Value with Price. The value is always contingent on a set of expectations. A
company normally will have different values for different buyers. If the price paid in an acquisition is
equal to the value for the buyer, then the value created by the acquisition equals zero. On the other
hand, do not forget that value is normally a number in an Excel worksheet, while price is very often
cash. There is a difference between $20 million cash and $20 million written in an Excel worksheet.
5. B . Asserting that a valuation is “a scientific fact, not an opinion.” A valuation has little to do
with science. A valuation is always an opinion.
5. C. A valuation is valid for everybody. A company normally will have a different value for the
buyer and for the seller.
5. D. A company has the same value for all buyers. A company normally will have different values
for different buyers.
5. E. Confusing strategi c value for a buyer with fair market value. The strategic value contains the
extra value (normally due to additional cash flow generation) that a given buyer thinks that he may get
from a company on top of what might be “normal” for other buyers.
5. F. Considering that the goodwill includes the brand value and the intellectual capital. Goodwill
is merely the difference between the price paid and the book value. There are many cases (especially
when interest rates are high) in which the price paid is less than the book value. An example is
Appendix 2: the book value of the shares was 10.76 million euros, and the shares were sold for 5
million euros. Does that mean that Pepsi’s brand value or the value of the “intellectual capital” was
negative?
5. G . Forgetting that a valuation is contingent on a set of expectations about cash flows that will
be generate d and about their riskiness. This is particularly important in certain acquisition
processes. Example: the valuation that a bidder had of the shares of a company was $273 million. But
there was another bidder that offered $325 million. The CEO of the first company asked its CFO to
prepare another valuation with a minimum of $350 million. The CFO increased expected sales,
expected margins and expected residual growth and got a valuation of $368 million. The CEO offered
$350 million, got the company and organized a celebration party.
20
6. A. Valuation without any check of the forecasts provided by the client. Often, the valuer will
ask the client for a forecast of the company’s cash flows (or a P&L forecast). And often , the valuer
will use this forecast (which sometimes is a letter to Santa Claus or the Three Kings), without
checking their validity. An example: A soft drinks bottling and distribution company gave an eight -
year forecast in which sales doubled every four years. However, the headcount was assumed to
remain constant and no significant investments were planned.
6. B . Commissioning a valuation from an investment bank and not having any involvement in it.
A fairly common error is to assign a valuation to an investment bank and wait for the valuation report.
Obviously, any such valuation will merely be the value of the company according to the investment
bank’s forecast (regarding the economy, the industry and the company) and the investment bank’s
appraisal of the riskiness of the company.
6. C. Involving only the finance department in valuing a target company . To obtain a decent
valuation, the sales, production, marketing, personnel, strategy, and legal departments also need to be
involved.
21
APPENDIX 1
List of errors
The most common errors are in italic

1. Errors in the discount rat e calculation and concerning the riskiness of the company
A. Wrong risk -free rate used for the valuation
1. Using the historical average of the risk-free rate.
2. Using the short-term Government rate.
B. Wrong beta used for the valuation
1. Using the historical industry beta, or the average of the betas of similar companies, when the result goes against common sense.
2. Using the historical beta of the company when the result goes against common sense
3. Assuming that the beta calculated from historical data captures the country risk.
4. Using the wrong formulae for levering and unlevering the beta.
5. Arguing that the best estimation of the beta of a company from an emerging market is the beta of the company with respect to the
S&P 500.
6. When valuing an acquisition, using the beta of the acquiring company.
C. Wrong market risk premium used for the valuation
1. The required market risk premium is equal to the historical equity premium.
2. The required market risk premium is equal to zero.
D. Wrong calculation of WACC
1. Wrong definition of WACC.
2. Debt to equity ratio used to calculate the WACC is different than the debt to equity ratio resulting from the valuation.
3. Using discount rates lower than the risk free rate.
4. Using the statutory tax rate, instead of the effective tax rate of the levered company.
5. Valuing all the different businesses of a diversified company using the same WACC (same leverage and same Ke).
6. Considering that WACC / (1-T) is a reasonable return for the stakeholders of the company.
7. Using the wrong formula for the WACC when the value of debt is not equal to its book value.
8. Calculating the WACC assuming a certain capital structure and deducting the outstanding debt from the enterprise value.
9. Calculating the WACC using book values of debt and equity.
E. Wrong calculation of the value of tax shields
1. Discounting the tax shield using the cost of debt or the required return to unlevered equity.
2. Odd or ad-hoc formulae.
F. Wrong treatment of country risk
1. Not considering the country risk, arguing that it is diversifiable.
2. Assuming that a disaster in an emerging market will increase the beta of the country’s companies calculated with respect to the
S&P 500.
3. Assuming that an agreement with a government agency eliminates country risk.
4. Assuming that the beta provided by Market Guide with the Bloomberg adjustment incorporates the illiquidity risk and the small
cap premium.
G. Including an illiquidity, small-cap, or specific premium when it is not appropriate

A. Wrong definition of the cash flows
1. Forget ting the increase in Working Capital Requirements when calculating Cash Flows.
2. Considering the increase in the company’s cash position or financial investments as an equity cash flow.
3. Errors in the calculation of the taxes that affect the FCF.
4. Expected Equity Cash Flows are not equal to expected dividends plus other payments to shareholders (share repurchases, …)
5. Considering net income as a cash flow.
6. Considering net income plus depreciation as a cash flow.
B. Errors when valuing seasonal companies
1. Wrong treatment of seasonal working capital requirements.
2. Wrong treatment of stocks that are cash equivalent.
3. Wrong tre atment of seasonal debt.
C. Errors due to not projecting the balance sheets
1. Forget ting balance sheet accounts that affect the cash flows.
2. Considering an asset revaluation as a cash flow.
3. Interest expenses not equal to D Kd.
D. Exagger ated optimism when forecasting cash flows.

A. Inconsistent Cash Flow used to calculate perpetuity.
B. Debt to equity ratio used to calculate the WACC to discount the perpetuity is different to the Debt to equity ratio resulting from the
valuation.
C. Using ad hoc formulas that have no economic meaning.
D. Using arithmetic averages instead of geometric averages to assess growth.
E. Calculating the residual value using the wrong formula.

A. Conceptual errors about the free cash flow and the equity cash flow
1. Considering the cash in the company as an equity cash flow when the company has no plans to distribute it.
2. Using real cash flows and nominal discount rates or viceversa.
3. The free cash flow and the equity cash flow do not satsify ECF = FCF + ?D – Int (1-T).
B. Errors when using multiples
1. Using the average of multiples extracted from transactions executed over a very long period of time.
2. Using the average of transactions multiples that have a wide dispersion.
22
3. Using multiples in a way that is different to their definition.

4. Using a multiple from an extraordinary transaction.
5. Using ad hoc valuation multiples that conflict with common sense.
C. Time inconsistencies
1. Assuming that the equity value will be constant for the next five years.
2. The Eq uity value or the Enterprise value do not satisfy the time consistency formulae.
D. Other conceptual errors
1. Not considering cash flows resulting from future investments.
2. Considering that a change in economic conditions invalidates signed contracts.
3. Considering that the value of debt is equal to its book value when they are different.
4. Not using the correct formulae when the value of debt is not equal to its book value.
5. Including the value of real options that have no economic meaning.
6. Forget ting to include the value of non-operating assets.
7. Inconsistencies between discount rates and expected inflation.
8. Valuing a holding company assuming permanent losses (without tax savings) in some companies and permanent profits in others.
9. Wrong concept of the optimal capital structure.
10. In mature companies, assuming projected cash flows that are much higher than historical cash flows without any good reason.
11. Assumptions about future sales, margins,etc. that are inconsistent with the economic environment, the industry outlook, or
competitive analysis.
12. Consider ing that the ROE is the return to the shareholders.
13. Considering that the ROA is the return of the debt and equityholders.
14. Using different and inconsistent discount rates for cash flows of different years or for different components of the Free cash flow.
15. Using past market returns as a proxy for required return to equity.
16. Adding the liquidation value and the present value of cash flows.
17. Using ad hoc formulas to value intangibles .
18. Arguing that different discounted cash flow methods provide different valuations.
5. Errors when interpreting the valuation

A. Confusing Value with Price.
B. Assert ing that “ the valuation is a scientific fact, not an opinion. ”
C. A valuation is valid for everybody.
D. A company has the same value for all buyers.
E. Confusing strategic value for a buyer with fair market value.
F. Considering that the goodwill includes the brand value and the intellectual capital.
G. Forget ting that a valuation is contingent on a set of expectations about cash flows that will be generated and about their riskiness.
A. Making a valuation without checking the forecasts made by the client.
B. Commissioning a valuation from an investment bank without having any involvement in it.
C. Involving only the finance department in valuing a target company.
23
Appendix 2. A valuation with multiple errors of an ad hoc method
The following is a summary of the valuation of a South European Pepsi-Cola franchise (a

bottling plant and a distribution company) made in 1990 by a consulting company. “The term ‘value of
the shares’ is defined as the estimated fair purchase or sale value for a free buyer and a free s eller, both
of whom are aware of all the relevant legal documents and neither of whom is acting under any kind of
duress.”
Table A2.1 shows the company’s balance sheets and P&L, actual and as forecast by the
financial consulting firm. Table A2.2 shows the valuation of the shares at 21.6 million euros. This
figure is obtained by first calculating the expected free cash flows (lines 1-4). Line 5 calculates the
present value of the free cash flows 1990-1994 at 17.48%, which gives 6.3 million euros. Line 6 is the
present value of the residual value calculated in lines 11-16. From the resulting value of the firm the
debt is deducted and the value of the investments is added to arrive at the figure of 21.6 million euros
as the value of the shares.
Table A2 .1. Balance sheets and P&L of BottlingSouth (million euros)

Actual Forecast
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Sales 10.52 13.38 14.88 19.40 20.97 23.33 25.96 27.79 29.90 32.32 34.79
Net income 0.89 1.50 1.69 2.15 1.49 1.35 1.83 2.27 2.82 3.65 4.22
Balance sheet 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Net fixed assets 4.04 5.02 5.87 7.46 9.88 11.63 12.31 13.04 13.84 14.70 15.60
WCR 1.17 1.81 2.25 3.34 3.95 4.68 5.19 6.11 7.18 9.05 10.69
Total assets 5.20 6.83 8.12 10.80 13.83 16.31 17.50 19.15 21.01 23.75 26.29
Financial Debt 1.28 1.60 1.54 2.40 4.13 5.55 5.55 5.55 5.55 5.55 5.55
Net worth 3.92 5.24 6.58 8.40 9.70 10.76 11.95 13.60 15.46 18.20 20.74
The risk-free interest rate at the time of the valuation was 13.3% and the year-on-year
inflation rate was 6.9%. Expected inflation was 5%.
This valuation contains at least five mistakes.
Table A2.2. Valuation of the shares of Bot tlingSouth (million euros)

million euros 1990 1991 1992 1993 1994
1 Net income 1.83 2.27 2.82 3.65 4.22
2 + depreciation 0.26 0.25 0.23 0.21 0.23
3 - investments in fixed assets 0.93 0.98 1.03 1.08 1.13
4 = FREE CASH- FLOW 1.15 1.54 2.02 2.78 3.32
5 Present value of Free cash flows at 17.48% 6.3
6 Present value of the residual value at 12.2% 19.8 =35.3 / (1,122)5
7 Enterprise Value 26.1
8 - Financial Debt -5.6
9 + Value of financial investments 1.0
10 Equity value 21.6
Residual value
11 Market value of Fixed assets in 1989 17.43
12 + New investments in Fixed assets in 1990-1994 5.1
13 - Loss in the value of fixed assets in 1990-1994 -3.00
14 + Working Capital Requirements in 1994 10.7
15 = Substantial value in 1994 30.3
16 Enterprise value in 1994 35.3 = 30.3 + 3.587 x (4.22 – 30.3 x 0.0933)
3.587 = Present value of 1 euro for 5 years, discounted at 12.2%
9.33% = Return on assets. 4.22 = expected net income in 1994
24
Errors:
1. Free cash flow calculation. The free cash flow is miscalculated because it includes interest (part of
net income) and does not include the increases in WCR. Table A2.3 shows the impact of these two
corrections on the free cash flow.
Table A2.3. Corrections to the Free Cash Flow calculation of Table A2.2.
1990 1991 1992 1993 1994
Wrong Free Cash Flow (line 4 of T able 9) 1.15 1.54 2.02 2.78 3.32
- increase in Working Capital Requirements 0.51 0.92 1.06 1.87 1.64
+ Interest expenses x (1 - 35%) 0.54 0.54 0.54 0.54 0.54
Corrected Free Cash Flow 1.18 1.16 1.50 1.45 2.22
2. The free cash flow of the years 1990 -1994 is discounted at a higher rate (17.48%) than the residual
value in 1994 (12.25%).
3. The discount rate used for the residual value in 1994 (12.25%) is lower than the risk -free rate
(13.3%).
4. The calculation of the residual value is very curious, but wrong. If we calculate the residual value as
a perpetuity that grows at a rate g based on the corrected free cash flow for 1994 (2.22), we get a rate
of growth of 10.5%. Obviously, this is absurd:
Residual value = 35.3 = 2.22 (1+g) / (0.1748-g). g = 10.5%
5. Overoptimistic net income and cash flow forecasts. One way to see just how overoptimistic they are
is to compare the growth of the dividends the company actually paid out over the period 1984-1989
with the dividend forecasts implicit in Table A2.2 (see Table A2.4). Over the previous 5 years
dividends had grown from 0.22 million to 0.3 million, whereas over the next 5 years they were
projected to grow from 0.3 million to 1.68 million. And let’s not forget that this is a soft drinks
company operating in a very mature industry.
Table A2.4. Dividends paid until 1989 and implicit dividends in the projections of Table A2.2
(million euros) 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Dividends 0.22 0.18 0.35 0.32 0.19 0.30 0.64 0.62 0.96 0.91 1.68
What happened?
The consulting firm that produced the valuation was asked to manage the sale at the price of 21.6
million, but they replied that they only did valuations. In the end, after various long-drawn-out
negotiations, the company’s shares were eventually sold for 5 million euros. Note that this is not such
a small amount: it assumes, if the dividends are discounted at 20%, that the 1989 dividends will grow
indefinitely at 13.2%. 5 = 0.3 x 1.132 / (0.2 - 0.132).
Table A2.5 shows the company’s net income after the valuation. Note the big difference between these
figures and the forecasts in Table A2.1.
Table A2.5. Net income of Bot tlingSouth after the valuation (million euros)
1990 1991 1992 1993 1994 1995 1996 1997
Net income 1.08 1.30 0.59 0.64 1.30 1.08 0.59 1.20
25
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27

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Pablo Fernández 80 common errors in company valuation

IESE Business School

80 common errors in company valuation

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

Keywords: company valuation, valuation errors, valuation

JEL Classification: G12, G31, M21

June 26, 2004

1.A. Wrong risk-free rate used for the valuation

1. B . Wrong beta used for the valuation

The average cost of equity is 7.25%.

Table 1. Main magnitudes of the INMOSEV valuation

1. C. Wrong market risk premium used for the valuation

Table 4. Historical equity risk premium in the U.S .

Average Annual Returns of Risk Premium

1. D. Wrong calculation of WACC

1. D.1. Wrong definition of WACC. An example:

Table 5. Valuation of a broadcasting company performed by an investment bank

Table 6. Valuation using the wrong WACC of 10%

Table 7. Valuation calculating the WACC correctly

Table 8. Valuation using the corrected WACC from Table 6

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

3. Errors in the calculation of the residual value

Table 9. Valuation of a manu facturing company performed by a financial consulting firm

Present value in 2002 of free cash flows (WACC =12%)

Table 11. Arithmetic vs. geometric growth

4. Inconsistencies and conceptual errors

4. B . Errors when using multiples

Table 12. Transaction multiples in the oil business

Table 13. Valuation using the price-earnings ratio.

Cash and banks 33 13 53 426 421 82

Short-term financial debt 0 0 2 2 0 1,124

Employees at 31 December 11 15 21 41 51 101

Decision of the Court of Arbitration

Table 15. Valuation of Terra performed by a Euro-American bank on 7 April 2000

No. inhabitants (million) 273

4. D. Other conceptual errors

The expected inflation is 2%.”

The most common errors are in italic

2. Errors when calculating or forecasting the expected cash flows

3. Errors in the calculation of the residual value

4. Inconsistencies and conceptual errors

3. Using multiples in a way that is different to their definition.

5. Errors when interpreting the valuation

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

The following is a summary of the valuation of a South European Pepsi-Cola franchise (a

Table A2 .1. Balance sheets and P&L of BottlingSouth (million euros)

Table A2.2. Valuation of the shares of Bot tlingSouth (million euros)

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