Thursday, July 3, 2014

Valuation Errors in Mergers and Acquisitions

We've noted many times that Value is Estimated, Price is Paid and that a main driver for creation or destruction of value is the price one pays up front.  Since estimated value is (hopefully) an upward bound on the price an acquiring firm will pay for a company it is instructive to investigate errors in calculating that value.  

A recent interesting article lists 119 common errors in valuation.  The article is authored by Pablo Fernandez and Andrada Bilan of  the University of Navarra - IESE Business School.  Their article provides a useful overview for organizing types of errors in valuation into six categories. 

Quoting from the article,

"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. "

We cover many of these in detail in our Acquisition Finance Course in Amsterdam.  I'll mention just a few clarifying comments here.  The categories above relate to:

1) Misjudging the risk of the acquiring company, errors in adjusting betas for leverage, etc.
2) Using hockey stick growth estimates that are not sustainable in the long run and incorrect projection of future cash flows.
3) Misestimating terminal value.  We've noted that 70-90 percent of a company's value is in the residual value.  It is important to get this right.  
4) Using incorrect cash flow estimates or inappropriate multiples.
5) Failure to recognize the strengths and weaknesses of various methods of estimation
6) Not adequately monitoring the valuation process

 The complete paper may be downloaded here.

All the best,


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