Top 9 Valuation Mistakes

Equity valuation is an important topic in finance.  Investors perform valuation on companies to determine whether the companies are reasonably priced.  Thus, investors shall minimize the mistakes in their valuation to maximize their investment return.

Andrew Stotz, CFA, President of CFA Society Thailand, outlined the top nine valuation mistakes in his recent presentation during an event organized by Securities Industry Development Corporation (SIDC) and CFA Society Malaysia.  The top nine mistakes are: -

1. Overly optimistic revenue forecasts;
2. Underestimating expenses causing unrealistic profit;
3. Growing fixed assets slower than revenue;
4. Confusing growth with maintenance Capex;
5. Forecasting drastic changes in cash conversion cycle;
6. Underestimating working capital investment;
7. Valuing a stock using the calculated Beta;
8. Choosing an unreasonable cost of equity; and
9. Not properly fading return on invested capital.

He also suggested the following steps to avoid making those mistakes.

1. Curb your enthusiasm on revenue forecasting;
2. Reduce focus to only Cost of Goods Sold and Selling General & Admin costs;
3. Over the long-run companies should grow fixed assets about as fast as revenue;
4. CAPEX consists of maintenance CAPEX and growth CAPEX; Maintenance CAPEX is the minimum and should be roughly the same as depreciation;
5. Avoid huge changes in working capital items, except in rare cases where there are changes in product mix or management policy;  
6. Unlike in accounting, in valuation we exclude cash and short term borrowing from net working capital;
7. Beta shall be in the range of 0.7x to 1.25x;
8. Based on our study we consider COE ranging between 8% and 12.5% to be reasonable; and
9. Fade highly profitable firms to 20% premium to WACC, unprofitable firms to 20% discount and no fading is required for average ROIC firms.

Investors who are interested to learn more about Andrew Stotz’s valuation technique can visit his website for more info.  http://valuationmasterclass.com/

Additional notes from Andrew on point no. 9 - 

"Many analysts make the mistake of forecasting that highly profitable companies will maintain that profitability for a long time. And that low profitability companies will maintain that low profitability for a long time too. But our work on this concept shows that very high ROIC fades down over about 3.5 years, low fades up over about the same amount of time. In both cases, they don't fade to average, but close to average. So to answer the question, in about Fading ROIC is done by the analyst reducing the company's operating profit (somewhat similar to net profit) forecast relative to their invested capital (somewhat similar to total assets) forecast."

https://youtu.be/n9FNHXGmy24

Sources: Stotz, Andrew and Lu, Wei, Financial Analysts Were Only Wrong by 25% (2015)