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Inconsistencies and conceptual errors in the company valuation method.

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Any method of Business Valuation is surrounded by numerous definitions, concepts and assumptions that must be remembered and applied correctly in order to arrive at an adequate and reasonable valuation.

It is common to hear that the Business Valuation is a process where common sense is applied, which does not exclude the existence of certain theoretical concepts that must be understood and applied correctly.

As explained in the last few entries of the category HowTo, many of these concepts contain the potential for numerous errors, most of which are related to their application.

However, the first step in making a good assessment is to have a clear understanding of what each of them means.

This will allow us to apply them correctly and avoid most of the inconsistencies that one could make.

We analyze below the most common inconsistencies and conceptual errors in this process.

6 conceptual errors in the company valuation method

1. Conceptual misconceptions about free cash flow and cash flow for equities

In the following, we will specify two errors inconsistent with its definition:

On the one hand, cash should not be considered as a flow to shareholders when the company has no intention of distributing it.

Given that both the free cash flow as the cash flow for the shares try to measure the cash available to be distributed within the company or among the shareholders, it makes no sense to add up the company's cash unless the company actually considers distributing it among them.

On the other hand, another conceptual error consists of using cash flows real rates and discount them to nominal rates, or vice versa.

All transactions in corporate finance must follow the same logic, either nominal or real.

Otherwise, figures will be obtained that cannot be considered correct because two completely different and inconsistent measurements will be used.

company valuation method

2. Mistakes when using multiples

The use of the method of valuation by multiples involves the risk of making numerous errors in relation to their definitions, their dispersion, their extension over time or their individual characteristics.

3. Temporal inconsistencies

Company valuation is based on the projection of cash flows and their discount at an appropriate rate, so the time horizon and the assumptions made about it are of enormous importance.

For example, it is not correct to assume that the value of the shares of a company with growth will be constant over the next few years, as this is only the case in perpetuities without growth.

In the remainder, the value of the shares in different years is related through the growth of the required rate less the cash flow for the shareholder.

4. Errors in valuing real options

Real options are those possibilities that a company has to introduce in the future, in certain projects, modifications in the productive investments, thus increasing the value of the project.

Thus, it is crucial to include and value only those options that really represent an economic significance for the company.

Thus, only those options that have a significant economic influence on the project in question can be considered as real options.

In line with this error, contracts that are not real options may be considered real options.

It is important to analyze each specific case and determine whether it is really an option exercisable by the company that can increase the value of a future investment.

Therefore, it makes no sense, for example, to consider as such an option that is shared with other companies and therefore does not depend solely on the will of the company under analysis.

5. Other errors

We can find another series of errors that, although not related to particular concepts, are related to the process of company valuation generation.

One of these mistakes is the failure to consider cash flows from expected future investments.

Although these investments are not currently being developed, it is necessary to include them in the forecasts and projections if they are expected to be carried out and are likely to have a significant impact on the company's future.

6. Accounting values and ratios

Other errors relate to accounting values and ratios.

On the one hand, considering that the book value of shares is a good approximation of their current value is a mistake. Book value cannot reflect many of the essential characteristics of a company that contribute to the generation of future cash flows.

On the other hand, ROA can be confused with the return to shareholders and debt providers (which depends mainly on changes in expectations). In reality, this ratio simply measures accounting profitability.

In addition, when analyzing the financial statements, it is important to note whether there are treasury shares, in which case they should not be taken into account when calculating the value per share, and should be treated as if they did not exist.

In summary of the whole valuation process, it cannot be stated that the different discounted cash flow methods provide different values.

All variants, if correctly applied, should provide the same value.

Es una conclusión lógica si se tiene en cuenta que todo método de valoracion de empresas analiza la misma realidad bajo las mismas hipótesis, cambiando únicamente los cash flows used as a starting point for assessment.

Source: 201 Common errors in company valuation. Pablo Fernández. 2008.

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