Valuation Analysis
Chart: Vale’s sudden rise of shares
Numerous factors contribute to the wrong valuation of prices of commodities and shares in the stock market. In the valuation of the shares, critical analysis of the stock and statistics is crucial in determining the intrinsic value of the share. However, valuation analysts make errors in determining the intrinsic value of shares, such as Vale’s case study. In vales case, the price valuation for the share rose from $ 14.17 to $49.47 in two weeks. The following factors would have led to a high miscalculation of the intrinsic value.
Use of Incorrect Beta Value during Valuation
Beta values are significant statistical values that help understand the measures of dispersion and return trends of a given security. In most cases, high beta values will signify higher volatility and high risk and high returns. Experts argue that the capital assets pricing model heavily depends on the beta values (Demirakos et al. (2004)). Vale’s company case study has a very high intrinsic value on the share, indicating that it’s possible that a greater beta value was used in the calculation of the intrinsic value. As can be seen, the value of beta used significantly affects the valuation as it raises the expected returns.
Additionally, wrong selection of the market portfolio and duration of returns are critical factors that affect regression analysis which is important in determining the beta values. The risk-free rate and market risk values have to be appropriately determined to get the correct expected return rates. Moreover, the equity risk premiums affect the beta values as they do not rely on the past figures and, therefore, can be responsible for giving capital errors in estimating the prices of a share.
Errors in evaluating the cash flows
These errors arise as a result arise from: having the recommendation to sell other than to buy. in intrinsic valuation, the buy recommendation becomes necessary when the market price is owed than the intrinsic share price (Demirakos et al. (2004)). Similarly, the selling option is preferable when the market price is greater than intrinsic share price. Again, vales example shows a problem in financial projection since it was done in a short time frame. This means that the predictions based on the current value ($14.17) were exaggerated. Vale company should have used a realistic time frame to analyse the price to be given for each share. Short period predictions, arguably, do not put into consideration all factors. Another factor that can contribute to errors is assumptions on the shares’ growth rates.
The Brazilian Vale’s company should have considered the necessary factors for the determination of the growth rate. This helps make an intelligent guess on the prices of shares. Real and nominal cash flows also need to be considered when evaluating the cash flow system (Demirakos et al (2004)). The real c and nominal ash-flow are beneficial in determining cash that comes in and out of business during inflation and normal economic growth periods.
Errors associated with the calculation of the WACC (Weighted Average Cost of Capital)
WACC refer to the minimum amount of returns expected by the investors or shareholders from the organizations that sell securities, shares or stocks (Fernandez, (2010)). Often, riskier projects are expected to give higher returns. Accurate calculation of the WACC becomes important because if it is properly done, it paves the way for approval of projects, and the vice vice-versa is true.
Numerous WACC errors arise from costs of equity and debts (Fernandez, (2019). The use of wrong models can lead to wrong calculations of the WACC. For instance, the Gordon Growth model doesn’t give the qualitative aspects of the future dividends, industry developments and management approaches (Fernandez, (2019)). The capital assets model is the most reliable in the quantitative analysis. If the company applies the accurate ACC values in their calculations, the result is a decrease in the cost of equity. Wrong definition of WACC.
Similarly, if there are differences in the debt-equity ratios in calculating the WACC, there will be errors (Fernandez, (2019)). Again, applying discount rates that are lesser than the risk-free rate will lead to errors. Applying the statutory tax rates in the place of effective tax will lead to errors in WACC calculation which eventually leads to wrong valuation (Fernandez, (2019)).
Wrong Calculation of the Value of Tax Shields
A tax shield is a deduction made from the taxable income that results in the decline of the tax to be paid. Its value is pegged on the individual’s or an organization’s tax paid; normally, higher taxation corresponds to a higher tax shield. Tax shields, in turn, affect a company’s capital structure. A company, therefore, may resort to using depreciation techniques and an appropriate tax shield formula to reduce the tax payment (Michalkova & Michalikova (2020)).
Calamities/Disasters
Natural and disease disasters such as tsunamis, hurricanes and pandemics may lead to a wrong price valuation. Also, these natural disasters and pandemics may destroy a countries political and economic system s thereby affecting critical business control factors. They may as well lead to inflation, which greatly affects the market securities.
The Hindsight Experience
It is beneficial because it helps an organization reflect on past experiences, correct mistakes, and improve. It also helps companies to have a broader picture of their prospects to help them achieve robust growth.
References
Demirakos, E. G., Strong, N. C., & Walker, M. (2004). What valuation models do analysts use?. Accounting Horizons, 18(4), 221-240.
Fernandez, P. (2010). WACC: definition, misconceptions, and errors. Business Valuation Review, 29(4), 138-144.
Fernandez, P. (2019). Watch and CAPM according to utility regulators: Confusions, errors and inconsistencies. Errors and Inconsistencies (February 19, 2019).
Michalkova, L., & Michalikova, K. F. (2020). Is the value of the new business tax shield lower? Comparative study of international valuation methods. In SHS Web of Conferences (Vol. 74, p. 01022). EDP Sciences.
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