Top 9 (unnecessary and avoidable) mistakes in cash flow valuation

Joseph Tham
& Ignacio Vlez-Pareja



First version: January 29, 2004

This version: January 29, 2004









Joseph Tham is Visiting Assistant Professor at the Duke Center for International
Development (DCID), Sanford Institute for Public Policy, Duke University and a
Research Associate at the Center for International Health and Development (CIHD) at the
Boston University School of Public Health (BUSPH). Email: ThamJx@duke.edu or
ThamJx@bu.edu.
Ignacio Vlez-Pareja is Finance Professor and Dean of the Industrial Engineering
School at the Politecnico GranColombiano, Bogota, Colombia. Email Address:
ivelez@poligran.edu.co
Our book, titled Principles of Cash Flow Valuation will be published by
Academic Press in January 2004.

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Abstract

In cash flow valuation (CFV), there are two main categories of mistakes:
derivation of the appropriate cash flows and estimation of the cost of capital. A simple-
minded view of the world would suggest that with near perfect capital markets, the
presence of arbitrage would severely punish wrong valuations and eradicate such
mistakes in the derivations of cash flows and estimations of the cost of capital.
Nonetheless, to the dismay of academics, such mistakes continue to exist and thrive. It is
not clear why such mistakes persist in practice.
In this paper we present our list of the top nine mistakes in cash flow valuation.
In the age of the computer these mistakes are both unnecessary and avoidable. In the
usual triumph of hope over experience, we are attempting to persuade analysts that they
would benefit from paying attention to these mistakes. Ultimately, the (un)importance of
the mistakes is an empirical question and depends on the considered judgment of
practitioners.

Word Count: 2,464


Keywords
Cost of capital, WACC, valuation

JEL Classification
D61: Cost-Benefit Analysis G31: Capital Budgeting
H43: Project evaluation




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There is no harm in being sometimes wrong
especially if one is promptly found out.

John Maynard Keynes, 1883-1946


Famous rules of thumb in finance
Whenever in doubt as to what is the right P/E to use,
use 10
If you dont know the RADR, use 10 percent.
The answer to almost any troublesome finance
question should include the word risk.
When in doubt, blame the accountants.

Quoted in Benninga & Sarig Corporate finance,
pg 90.


Why did we show the book balance sheet? Only so
you could draw a big X through it. Do so now.

Brealey & Myers in Principles of Corporate
Finance, Seventh Edition, pg. 525.



Introduction
In cash flow valuation (CFV), there are two main categories of mistakes:
derivation of the appropriate cash flows and estimation of the cost of capital.
1
A simple-
minded view of the world would suggest that with near perfect capital markets, the
presence of arbitrage would severely punish wrong valuations and eradicate such
mistakes in the derivations of cash flows and estimations of the cost of capital.
Nonetheless, to the dismay of academics, such mistakes continue to exist and thrive. It is
not clear why such mistakes persist in practice.
The easiest charitable answer is that these mistakes are really simplifying
assumptions and do not matter very much, except to the academics. In other words, the

1
. For a more extensive list of mistakes, see Fernandez (2003).

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assumptions roughly describe reality.
2
Moreover, in the real world the informational
deficiencies are so severe that refinements in the derivation of the cash flows and
estimations of the cost of capital would make no difference in the final analysis (or
decision) and the rough rules of thumb are sufficient for most practical purposes.
The most obvious (unsatisfactory) answer is the ignorance of the analysts.
3
In this
line of reasoning (which is the secret hope of the academics), if only the analysts realize
and are convinced that they are making mistakes, they would see the errors in their ways
and adjust their practices accordingly. And to the extent that the herd mentality
prevails, there would be a consensus among the analysts.
In spite of misgivings about the value of identifying and discussing the common
mistakes in valuation, in this paper we present our list of the top nine mistakes in cash
flow valuation and briefly and informally comment on them. In the age of the computer
these mistakes are both unnecessary and avoidable. In the usual triumph of hope over
experience, we are attempting to persuade analysts that they would benefit from paying
attention to these mistakes. Ultimately, the (un)importance of the mistakes is an empirical
question and depends on the considered judgment of practitioners.
First, we list the top nine mistakes. Second, we briefly comment on the nature of
the mistakes and how they can be easily avoided.
1. Incorrectly using WACC formulas derived from cash flows in perpetuity for finite
cash flows.

2
. Page 259, Benninga and Sarig (1997).

3
. For example, in investment decision making and capital budgeting, practitioners continue to use the
internal rate of return (IRR) and the payback period. In recent years, even the hallowed net present
value (NPV) criterion has come under heavy criticism for not taking into account option value.

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2. Incorrectly constructing cash flows in real terms (or worse, in constant values)
rather than nominal terms.
3. Using book values rather than the (correct) market values to calculate the weights
for debt and equity in the Weighted Average Cost of Capital (WACC).
4. Assuming that the return to levered equity in the WACC is constant even when
the leverage is variable.
5. Specifying the return to levered equity and the return to unlevered equity as
independent parameters.
6. Incorrectly assuming that the tax shields are always realized in the year in which
they occur.
7. Not verifying that the sum of the free cash flow (FCF) and the tax shield (TS)
must equal the sum of the cash flow to debt (CFD) and the cash flow to equity
(CFE).
8. Incorrectly excluding the cash and marketable securities as part of the adjustment
for the change in the New Working Capital (NWC) in the derivation of the free
cash flow (FCF). This leads to an error in the estimation of the cash flow to equity
(CFE).
4

9. Not verifying that the sum of the present value (PV) of free cash flow (FCF) and
the PV of the tax shield (TS) must equal the sum of the PV of the cash flow to
debt (CFD) and the PV of the cash flow to equity (CFE).

4
. For example, see pg 36 in Benninga & Sarig (1997). They state Cash and marketable securities are the
best example of working capital items that we exclude from our definition of NWC, as they are the
firms stock of excess liquidity. (Italics in original)

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1. Incorrectly using WACC formulas derived from cash flows in perpetuity for
finite cash flows.
This assumption is simply false and we do not understand why this error persists
in practical work. With the availability of cheap computing power, the continued
application of formulas derived from cash flows in perpetuity for finite cash flows is
inexplicable.
For example, often, analysts assume that the popular formula for the
relationship between the return to unlevered equity and the return to levered equity for
cash flows in perpetuity also hold true for finite cash flows, and consequently they use
the popular formula to calculate the return to levered equity in the WACC.
Many analysts do not realize that the appropriate discount rate for the tax shield is
implicit in the specification of the formulas for return to levered equity and the WACC.
Thus, it is very important to check for the consistency between the appropriate risk-
adjusted discount rate for the tax shield, the nature of the cash flow (finite or in perpetuity
with and without growth).
2. Incorrectly constructing cash flows in real terms (or worse, in constant
values) rather than nominal terms.
The correct way to construct cash flows is in nominal terms. However, analysts
continue to assume that the final results do not depend on whether the cash flows are
constructed in nominal or real terms.
5
In fact, the authors of many textbooks assert that
the nominal prices and real and constant prices approach give the same results, with one
important caveat on the issue of consistency between the cash flows and the discount

5
. Constructing cash flows in constant values requires the additional heroic assumption that there are no
real changes in the values of the items that constitute the cash flows.
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rates. They say that the methods will give the same results as long as the nominal free
cash flows are discounted with the nominal discount rate, and the real and constant free
cash flows are discounted with the real discount rate. They also say that the cash flows
and discount rates must be consistent; if the free cash flows are nominal, then the
discount rate must be nominal, and if the free cash flows are real, the discount rate must
be real.
The consistency between the cash flows and the discount rates is NOT sufficient
to obtain identical results. Due to taxes and other issues, the present value of the cash
flows, derived from financial statements that are constructed in nominal terms,
discounted at the nominal discount rate does not equal the present value of the cash
flows, derived from financial statements that are constructed in real terms.
3. Using book values rather than the (correct) market values to calculate the
weights for debt and equity in the Weighted Average Cost of Capital
(WACC).
It is well-known that the weights in the celebrated after-tax WACC applied to the
free cash flow (FCF) are based on market values. However, analysts continue to use book
values even when the book values are not close to the market values. The use of book
values in the estimation of the WACC should be explicitly acknowledged, even if they
are employed as a last resort.
4. Assuming that the return to levered equity in the WACC is constant even
when the leverage is variable.
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The return to levered equity is a positive function of the debt-equity ratio.
Analysts assume that the return to levered equity is constant even when the leverage is
obviously fluctuating widely during the life of the cash flow profile.
5. Specifying the return to levered equity and the return to unlevered equity as
independent parameters.
Some analysts specify the return to levered equity and the return to unlevered
equity as independent parameters even though they cannot be independent.
6. Incorrectly assuming that the tax shields are always realized in the year in
which they occur.
Often, analysts incorrectly assume the tax shields are always realized in the year
in which the tax shields occur, even when they know that this assumption is not true. Tax
shields are only earned when taxes are actually paid.
7. Not verifying that the sum of the free cash flow (FCF) and the tax shield (TS)
must equal the sum of the cash flow to debt (CFD) and the cash flow to
equity (CFE).
The relationship between the FCF, TS, CFD and CFE is fundamental. Yet
analysts do not bother to verify the relationship and this leads to the next mistake.
8. Incorrectly excluding the cash and marketable securities as part of the
adjustment for the change in the Net Working Capital (NWC) in the derivation of
the free cash flow (FCF); this leads to an error in the estimation of the cash flow to
equity (CFE).
Related to this relationship is the treatment of the excess cash in the business,
which is invested in short-term marketable securities. The equity holder does not actually
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receive the cash that is invested in marketable securities and consequently, it must not be
included in the cash flow to equity. The cash flow to equity consists of the actual cash
flows. From the point of view of the business enterprise, the cash and marketable
securities are retained in the business, and thus they should be included as part of the
adjustment for the change in the NWC.
6

9. Not verifying that the sum of the present value (PV) of free cash flow (FCF)
and the PV of the tax shield (TS) must equal the sum of the PV of the cash
flow to debt (CFD) and the PV of the cash flow to equity (CFE).
The relationship between the present values of the FCF, TS, CFD and CFE is
fundamental. Yet analysts do not bother to verify the relationship. Furthermore, all of the
different discounted cash flow (DCF) approaches must match the results from the
Economic Value Added (EVA) approach and the Residual Income Method (RIM). As a
check on the consistency of the valuation exercise, it is important to verify that the results
from DCF methods, the EVA and RIM match.

6
. To document the existence of this error in the derivation of the CFE, we cite references from three
popular books on valuation. Earlier, we had mentioned the book by Benninga and Sarig. Damodaran
(1996) on page 101 provides the following definition for the CFE.

Revenues Operating Expenses Depreciation and Amortization Interest Taxes = Net Income

Net Income + Depreciation and Amortization Preferred Dividends Change in Working Capital
Principal payment + New debt = CFE.

Damodaran (1996) on page 99 writes: Since funds tied up in working capital cannot be used elsewhere
in the firms, changes in working capital affect the cash flows to the firm increases in working capital
are cash outflows and decreases in working capital are inflows. [] The accounting definition of
working capital includes cash in current assets. This is appropriate as long as the cash is necessary for
the day-to-day operations of the firm. Increases in cash beyond this requirement should not be
considered in calculating working capital for the purposes of cashflow calculation, since an increase in
working capital as a consequence of cash accumulating in the firm is not a cash outflow to the firm.

Copeland, T. et al. (1996) in the second edition give a similar definition to that of Damodaran.
However, Copeland, T. et al (2000) in the third edition provide a different but correct and consistent
definition, in which the sum of the FCF and the TS equals the sum of the CFE and the CFD. Simply
stated, the CFE is the sum of all the actual cashflows received or paid by the equity holder.

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Conclusions
We have briefly described nine common mistakes in cash flow valuation. We
hope that the recognition of these mistakes will improve practical cash flow valuation.
References
Benninga, S. and Sarig, O. (1997) Corporate finance. McGraw Hill
Copeland, T. et al. (1995) Valuation: measuring and managing the value of companies .
Second edition, Wiley.
Copeland, T. et al. (2000) Valuation: measuring and managing the value of companies .
Third edition, Wiley.
Damodaran, A. (1996) Investment Valuation. Wiley.
Fernandez, P. (2003) 75 common and uncommon errors in company valuation. Working
Paper on Social Science Research Network (SSRN).
Tham, J. and Vlez-Pareja, I. (2004) Principles of cash flow valuation. Academic Press.

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Thursday, January 29, 2004