How to Avoid Mistakes in Valuation: Guidelines for Practitioners
98 Pages Posted: 14 Mar 2011
Date Written: March 13, 2011
The cash flows discounting is a conventional and theoretically sound approach to valuing firms and projects. Although it is intuitively easy and attractive, the practical implementation is not without challenges. At the first sight the discounting procedure is a simple and routine task, which does not involve much effort. But actually even in simple cases accurate valuation requires attention to plenty of details. The slightest negligence or insufficient knowledge of underlying theory can result in substantial inaccuracy.
Sometimes practitioners manifest the fatal conceit of professing disdain for theory. They presume that their experience provides a solid ground for developing complex models. As a result they mostly rely on their intuition and past situations and eventually encounter on fundamentally new or counter-intuitive problems where the intuition has no power and leads to mistaken decisions. In contrast theoretical understanding consists in rational thought and meaningful explanations about a given subject matter in its entirety, considering the matter from different sides and with investigation of cause and effect relationships. As well as the experience can be rich or poor, theories can be imperfect or even controversial. And actually not every set of words can be called a theory. Theory is constructed of a set of true interrelated logical statements about the subject under consideration and it reflects the up to date state of knowledge about the matter. With respect to valuation, theory plays a crucial role, as there are no simple empirical methods to find value of a business or project from observable data. The whole profession is erected on theoretical constructions such as concepts of utility, time value of money, risk avoidance, market equilibrium and other related economic, financial and accounting concepts. This implies not only strong attention to specific theoretical issues suggesting a meaningful guidance to practical problems but also a systematic view and deep understanding of interrelationships between various concepts and variables. Such understanding should be extended to building valuation models and calculations.
The present paper intends to investigate the most error-prone, obscure and controversial issues concerning valuation. It also covers some important moments that are often overlooked in textbooks and professional literature. Perhaps, a portion of the paper repeats existing research; however, it is inevitable to ensure a consecutive and consistent writing.
At the same time the paper has no purpose to revise the up to date theory, but is mostly oriented on systematization and filling the gaps. The paper focuses only on the practical matters and stands aside chiefly fundamental questions such as determining a magnitude of discount rate. A common wisdom says that knowing a few principles is worth the knowledge of a lot of facts. So the paper has a strong incentive to center mostly on revealing general rules instead of describing all possible cases and situations that may encounter in valuation practice and of providing detailed instructions on how to treat each of the special problems.
Keywords: Valuation, Cash Flow, WACC, Cost of Equity, Financial Leverage, Cost of Levered Equity, Cost of Unlevered Equity, Forecasting
JEL Classification: M21, M40, M46, M41, G12, G31, J33
Suggested Citation: Suggested Citation