Pablo Fernandez, the professor of finance at IESE Business School, remains one of the most thoughtful observers of business valuation practices. His latest paper, published late last week, addresses ‘the most common error in valuations using WACC.’
As usual, his short analysis provides not only humour, but also reason for concern. He compares two valuations from the same investment bank using income approach methods—the first prepared based on the present value of expected free cash flows and the second based on the present value of expected equity cash flows.
The result? Sadly, two different values: €6.9 million using the first method, and €4.2 million using the second.
While not every valuer will agree with Fernandez’s assumptions in his two models, the point is clear that many analysts don’t distinguish appropriately between their WACC assumptions and the required return to equity investors demand. Fernandez concludes ‘this is the most common error in discounted cash flows valuations (both methods do not provide the same value) and it is due to “follow a recipe without thinking”’.