The valuation of firms, projects, and transactions is one of the most fundamental processes in business and finance. It directly affects investment decisions and the allocation of resources in the economy. As a result, there is a vast amount of academic work on the topic. This material is widely taught at all levels of higher education, using textbooks such as Berk and DeMarzo (2013) and Brealey et al. (2013). Academics and those that do valuation for a living do not always agree over the implementation, or relevance, of theory. Practitioners are sometimes dismissive of 'academic' ideas, as illustrated by this consultant's response to a recent survey that we performed:1
“There seem to be lots of academics asking how analysts in the real world use CAPM or calculate the cost of capital. The answer is, people don’t waste time on this. No one ever lost/made money because they calculated the WACC better than consensus. You accademic [sic] guys are wasting your time.” (Mukhlynina and Nyborg 2016).
If these views are widespread, this raises questions about what academics teach and the effectiveness of higher-level finance education. There are also questions about the valuations that the professionals come up with, because they are intermediaries in the capital allocation process. There is little systematic knowledge on the favoured techniques, and the factors that affect the choices made by valuation professionals. How important is their level of education, or their professional subgroup? How important is the purpose of the valuation?
The most established methods used to value a project or a company are relative valuation ('multiples') and multi-period models. Finance textbooks emphasise the latter, and especially the technique of discounted cash flows (DCF). Approaches differ on several levels: by the inputs one needs to consider, by the caveats one has to be aware of, and, most crucially, by the results one gets.
Anecdotally, some practitioners are of the opinion that the DCF technique is too academic and theoretical. In contrast, multiples are viewed as delivering market-oriented results in addition to being easier to implement. As expressed by the consultant in the quote above, the cost of capital, a major input into a DCF valuation, is sometimes viewed as an academic concept that has little practical relevance. It is not clear how widely held this belief is or, in general, how popular multiples really are.
In our recent work, we use a survey to shed light on these issues (Mukhlynina and Nyborg 2016). We map the ways in which professionals go about the business of valuation. This basic analysis is used to determine the factors that affect a valuation professional's choice of method and implementation.
We find support for the 'sociological hypothesis' that profession matters more than education, and found that different professions have different valuation cultures. So in practice, the values attached to different firms and projects – on which resource allocation may depend – depend on 'where' a valuation is carried out.
Which methods were chosen?
The vast majority of the survey respondents typically employed both relative valuation and multi-period models. About half had a preference for each method. By far the most popular multiple is EV/EBITDA,2 with 84% in our sample saying they always, or almost always, use this when they use multiples. Respondents favoured 12-month forward estimates of earnings. On average they employed eight comparables, picked primarily from rivals in the same industry, also paying attention to size and expected growth.
The most popular multi-period model was DCF. Respondents typically discounted expected cash flows at the weighted average cost of capital (WACC), with the cost of debt estimated by the risk-free rate plus a spread. The cost of equity was estimated by the Capital Asset Pricing Model (CAPM). Multifactor models were rarely used. The risk-free rate is most commonly taken to be the yield on a long-term Treasury security. Cash flows were typically projected only for five years. Terminal values were calculated using the Gordon growth model, with the most popular choices of growth rates being 2%, and expected GDP growth.
With these choices, and with realistic assumptions on the discount rate and forecasting horizon growth rates, the fraction of the total gross value of a project that can be attributed to the terminal value is around 70%. This underscores the practical significance of the forecasting horizon, and the terminal value. It also implies that the way the technique of DCF is implemented in practice means that it becomes almost just another multiples exercise, with the majority of the estimated value attributable to the forecasted cash flow in the first year after the forecasting horizon, multiplied by one over the discount rate less the growth rate.
Respondents discounted cash flows at the WACC. It is clear from their answers to other questions, though, that they were confused about the well-known textbook result that the WACC is sensitive to leverage because of interest tax shields. Generally, respondents did not have a deep understanding of how to deal with tax shields when they carried out DCF analysis. This professional confusion challenges finance academics to improve their teaching.
How these methods were chosen
What factors affect the professionals’ choice of valuation method? We frame this as a contest between educational background and professional subgroup (consulting, investment banking, private equity, or asset management). But we also investigate (and controlled) for other respondent characteristics, especially paying attention to the type of investment (project finance, listed firms, unlisted firms, real estate) and the type of transaction (mergers and acquisitions, investment decisions, going public or private). We also look at the purpose of the valuation – whether the respondent is on the buy side, the sell side, or in an advisory role.
We may expect valuers with a more advanced degree to use more sophisticated methods and make fewer conceptual mistakes. But sociology and social psychology also recognise that professions have identifiable cultures, and that individuals are influenced by peers and groups (Asch 1955, Greenwood 1957). Therefore, it is also plausible that cultural norms within professional subgroups affect the approach that members of the group prefer. Robert Shiller was an early proponent of some of these ideas (Shiller 1984).
Our comparison of the influence of education versus professional subgroup was motivated by Harris (1995, 1998), who demonstrated that children’s values and behaviour are influenced more by peers than by upbringing at home. Our hypothesis is that valuation professionals would adopt the ‘valuation culture’ of their professional subgroup, rather than the methods from their educational background. We rest this by examining differences in valuation approaches across professional subgroups, because there is no a priori reason why one profession should use more sophisticated valuation methods than another.
We find that there are distinct differences in several elements of the choice of technique across professions. Furthermore, these differences are not related to sophistication. Education has much less influence on this choice. The purpose of the valuation has little effect on the choice of technique.
This implies that there is a degree of arbitrariness about valuations in practice. They are influenced by where the valuation is carried out. Also, education is relatively unimportant in practice, which suggests that higher-level finance education may have more impact if is carried out in the workplace. This may well also be true for other business and management subjects where many theories and approaches flourish. We may ask what role finance education has beyond a bachelor's degree. Is it merely a sideshow?
Asch, S. (1955), “Opinions and social pressure,” Scientific American, 193, 31–35.
Berk, J. and D. DeMarzo (2013), Corporate Finance, Prentice Hall.
Brealey, R., S. Myers, and F. Allen (2013), Principles of Corporate Finance, McGraw-Hill.
Greenwood, E. (1957), “Attributes of a profession,” Social Work, 2, 45–55.
Harris, J. (1995), “Where is the child’s environment? A group socialization theory of Development,” Psychological Review, 102, 458–489.
Harris, J. (1998), The nurture assumption: Why children turn out the way they do, Free Press.
Mukhlynina, L. and K.G. Nyborg (2016), “The choice of valuation techniques in practice: Education versus profession,” University of Zurich, SFI, and CEPR working paper.
Shiller, R. (1984), “Stock prices and social dynamics,” Brookings Papers on Economics Activity, 2, 457–510.
 A report summarising the key findings of the survey, including condensed tables and figures, can be found at www.nyborg.ch.
 EV is enterprise value. EBITDA is earnings before interest, depreciation, and amortization.