When famous value investors like Seth Klarman or Dan Abrams talk about value investing, they typically focus on the psychological and behavioral aspects of it: the confidence to bet against the market, and the honesty to acknowledge when your thesis hasn’t panned out and you need to cut your losses. That assumes investors have the technical skills necessary to calculate a company’s value, but drawing on thousands of valuations he’s reviewed during his career University of Navarra professor of finance Pablo Fernandez has found that people often make the same avoidable errors.
Basic errors when calculating valuations
The first three errors in Fernandez’s list are all problems with the calculations themselves: discount rate, cash flow, and residual value calculation errors. When doing a discount rate calculation he finds that people often use the wrong risk-free rate or the wrong beta (eg the beta of an acquiring company when valuing the acquisition), the incorrect treatment of country risk, the application of incorrect or inappropriate premiums (eg applying a small-cap premium to all companies regardless of size), and the application of ‘odd or ad-hoc formulae’.
Cash flow errors are similarly mostly about nuts and bolts: incorrect definitions and formulae, errors in dealing with seasonal debt/working capital, and completely ignoring how balance sheets and cash flows affect each other. He does also mention ‘exaggerated optimism when forecasting cash flows.’ People make mistakes when calculating residual value by using inconsistent cash flows to calculate perpetuity, using the wrong year to start calculating the perpetuity or just using ‘ad hoc formulas that have no economic meaning.’
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Poor organization and failures of common sense round out the list
The fourth common mistake that Fernandez identifies is the failure to realize that valuations and prices are different, and that even correct valuations will vary depending on the buyer. Strategic considerations mean that an acquisition target may be, and often is, more valuable to one company than it is to another without either potential buyer being mistaken.
Next, Fernandez says that he sees organizational mistakes that amount to analysts and investors not double checking other people’s work. Accepting client’s cash flow forecasts without checking that they’re reasonable or only involving the finance department in doing valuations are two example of organizational problems that can lead to bad valuations.
Finally, Fernandez has one category of mistakes that are best labeled as failures of common sense (he calls them inconsistencies and conceptual errors). Comparing values at different points in time, using a single exceptional deal as a basis for valuing other companies, ignoring cash flows from future investments, or (again) ad hoc formulas to attach a value to intangible assets. It’s a bit of a catch-all category, but you’d have a hard time arguing that it isn’t common.
See full PDF below.
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