The difficulty of a valuation does not lie in applying any of the available methods, but rather on the ability to predict the future. In practice what is valued is the business model, the company strategy, the attraction of its products, its prospects and its risks.
Below we outline a series of pitfalls common among analysts and investors related to the valuation of a company.
Pitfall 1: Inaccurate prediction of growth rates
Forecasts of continuous high market growth rates are usually not realistic. Initially much higher expectations in revenues, later give place to lower growth or even significant decline.
In the “dot-com bubble” investment banks fueled speculation and encouraged investment in technology. Many investors were willing to overlook traditional metrics and base confidence on technological advancements. At the peak of the boom, it was possible for a promising dot-com company to become a public company and raise a substantial amount of money even if it had never made a profit or realized any material revenue.
Pitfall 2: Assuming that growth will come from non-core business activity
The average company succeeds only 25% of the time in non-core business activities. Companies that have hit upon a repeatable formula that can be adapted to a slightly different environment drive their rates up to 80% or higher. That’s because growing a business is normally a complex, experimental, and somewhat chaotic process. Repeatability allows the company to systematize the growth and, by doing so, take advantage of learning-curve effects.
Pitfall 3: Basing growth on mergers and acquisitions
According to research and HBR report, the failure rate for mergers and acquisitions (M&A) sits between 70 percent and 90 percent. The causes lie in the following three main reasons:
- Integration risk: the integration of the operations of two companies is a difficult process and cost savings from synergies and economies of scale might not be achieved.
- Overpayment: in case a substantial premium is offered, the optimal scenario considered from the acquirer’s perspective might not be achieved. Such overpayment can have a significant impact on the company’s performance.
- Cultural Fit: M&A transactions may also fail due to extremely different corporate cultures between the two parties.
Pitfall 4: Growth coming from increased supply
In some cases, following an increased demand, supply increases at a much higher rate resulting in lower profitability for the entire sector in question.
An example was the overcapacity of the steel industry. When steel mills are underused, they use raw materials less efficiently and producers are forced to reduce prices to win orders and cover their high fixed operating costs. This resulted in a collapse in the price of steel four years ago. The decline in profits lead to major job losses and put at risk the industry’s future in many countries.
Pitfall 5: Business model failure
Market growth forecasts are correctly predicted however companies fail to exploit these opportunities and transform increased demand into revenues and profits.
BlackBerry devices were leading the mobile phones' sector for many years. Despite the increased demand for smartphones and its leading position Blackberry did not recognize the paradigm shift from smartphones being communication devices to being portable computers when iPhones / Androids were introduced and as such the company did not adapt its business strategy accordingly.
Pitfall 6: Accurate revenue growth but with lower margins
The projected demand growth rates are confirmed; however, the industry's profit margins shrink leading to lower profits than initially projected. The profit margin is strongly dependent on the economic moat of the company. According to Warren Buffet's framework it is the ability of a business to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.
Pitfall 7: Forecasts based on Boom or Peak of the business cycle
Many sectors are characterized by cyclical activity, where a series of growth periods (boom and peaks) are followed by periods of decline (recessions, depressions).
A major pitfall occurs when the analyst ignores the existence of the business cycle and predicts growth “linearly”. Cyclical industries include commodities (chemicals, paper, aluminum, sugar, steel, etc), construction, finance, real estate, construction machinery (i.e. Caterpillar), consumer discretionary (luxury handbags, designer jeans, diamond rings), mining, consumer durables (such as new refrigerators, furniture and cars), shipping, airlines, travel, etc
Pitfall 8: Inaccurate financial reporting
Inaccurate financial reporting leads to bad decision-making and executives fail to prepare and implement appropriate long-term plans. Additionally, such a practice will decrease the company's credibility with the various stakeholder’s (board of directors, shareholders, banks) and could even lead to the closure of the company in more serious cases. Examples include WorldCom, Petrobras, Enron, Kmart, Nortel etc.
Pitfall 9: Current state of the economy and prospects
Any business operating in the global economy can be affected by real-world events both positively and negatively (oil price increases, currency exchanges, financial crisis, Brexit). Leading indicators in the global economy must be considered in order to proactively account for these events and adjust the forecasts accordingly.