Pablo Fernandez on common errors using WACC

BVWireIssue #208-2
January 15, 2020

cost of capital
cost of capital, discount rate, weighted average cost of capital (WACC), cost of equity, equity risk premium (ERP)

A new paper presents a real valuation a well-known investment bank performed using two usual methods that are supposed to provide the same value. The trouble is the bank came up with very different values using the two methods. The reason: “Following a recipe without thinking,” says Pablo Fernandez, a professor in the department of financial management at the University of Navarra—IESE Business School in Spain. He is a widely published author (ranked No. 1 in downloads on SSRN) who conducts a regular survey of market risk premiums and risk-free rates used in countries around the world.

Out of sync: In the new paper, “The Most Common Error in Valuations Using WACC,” he explains that there are two usual methods to value shares that, if properly applied, provide the same value: (1) the present value of expected free cash flows discounted with the WACC rate and then subtract the value of debt; and (2) the present value of expected equity cash flows discounted at the 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,” he writes. But, in many cases, valuers come up with different values, he observes.

Readers of BVWire should be familiar with the views Fernandez has about the overuse of math as a way to avoid necessary judgment. “The main thing I see is too little use of common sense,” he once told us. “Many valuators want to take a theory and a recipe, apply it, and justify it by simply saying that it’s commonly used by others.” He sees many valuation reports that talk only in terms of models and “almost nothing in terms of how the world really works.” Part of the reason is the nature of consulting. “Consultants tend to bombard clients with math or jargon to confuse, impress, or justify the fee,” he says. “It’s not about what the client understands of what you’re telling them. In finance—actually in most jobs—you put in a lot of words—strange words—and you use a lot of synonyms so that the people not devoted to the topic understand almost nothing.”

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