Saturday, 3 June 2017

Valuation Model should be tested for Validity and Sensitivity to Various Inputs and Economic Forecasts

Once the valuation model is complete, it should be tested for its

  • validity, 
  • sensitivity to various inputs and 
  • sensitivity to various economic forecasts.

(a)  Validity

A model's validity can be questioned if there are mechanical errors or flaws in economic logic.

(b)  Sensitivity to Various Inputs and Economic Forecasts

Understanding how sensitive the valuations are to key input and economic conditions gives a more robust understanding of

  • the long-term value drivers for a firm and 
  • the potential for large swings in value.

Checks and Balances

Verifying valuation results involves checks and balances to see if the model is technically robust by addressing the following relationships:

  • that the balance sheet balances and the correct relationships exist among income, retained earnings, and dividends;
  • that the sum of invested capital plus nonoperational assets equals the cumulative sources of financing; and 
  • that the change in excess cash and debt line up with the cash flow statement.

A good model will have automatic checks for these relationships.

Economic Consistency

Checking for economic consistency involves seeing if the results reflect appropriate value driver economics; for example, high growth and return should be reflected in value of operations higher than book value.

Check also to see if the patterns of key financial and operating ratios are consistent with economic logic and in general, check to see if the results are plausible.

Sensitivity Analysis

Sensitivity analysis aids in determining the impact of changes of key drivers, and scenario analysis allows for assessing results under a broad set of conditions.

Valuation can be very sensitive to small changes in assumptions, which is why market values fluctuate.

A good guide is to aim for a valuation range of +/- 15%, which is similar to the range used by investment bankers.

No comments: