The Most Common Error in Valuations using WACC

Abstract

To value shares there are two usual methods that, if properly applied, provide the same value: 1/ Present value of expected free cash flows (FCF) discounted with the WACC rate and then, subtract the value of debt; and 2/ Present value of expected equity cash flows (ECF) discounted with the Ke rate (required return to equity).

Both valuations must provide the same result because both methods analyze the same reality under the same hypotheses; they differ only in the cash flows taken as the starting point for the valuation.

But in many valuations performed by investment banks, analysts, consultants, finance professors… both methods do not provide the same value.

This paper presents a real valuation performed by a well-known investment bank, with two very different values: €6,9 million using method 1/, and €4,2 million using method 2/.

Keywords: company valuation; WACC; required return to equity; discounted cash flow; equity cash flows; free cash flows

JEL Classification: G12, G31, M21