Valuation Model Pitfalls#

Even with honest financial statements, the valuation model itself can be flawed. Aswath Damodaran highlights these critical errors in thinking.

1. False Precision#

"This stock is worth $127.43."

• The Excel Trap: Just because Excel can calculate to 10 decimal places doesn't mean you know the future that accurately.
• The Reality: Valuation is an estimate. It has error bars.
• The Fix: Be suspicious of hyper-precise numbers. A simple model with 3-5 key drivers is often better than a 50-tab spreadsheet. "The stock is worth between $110 and $140" is a much more honest answer.

2. The "China Growth" Fallacy#

"The company will grow at 20% for the next 20 years."

• The Reality: As companies get bigger, it becomes mathematically impossible to maintain high growth rates. If a company grows faster than the economy forever, it becomes the economy.
• The Fix: Always fade growth rates down to the risk-free rate (or GDP growth rate) in the terminal year. This is called "Mean Reversion."

3. Mismatching Discount Rates#

Using a Cost of Equity to discount Firm Cash Flows (FCFF).

• The Rule:
  • If you project Cash Flow to Equity (FCFE), discount at Cost of Equity.
  • If you project Cash Flow to Firm (FCFF), discount at WACC.
• The Mistake: Mixing these up will double-count or ignore debt, leading to wildly wrong values.

4. Bias: The Biggest Input#

Who built the model?

• Sell-Side Analyst: Incentivized to issue "Buy" ratings to keep corporate clients happy.
• M&A Banker: Incentivized to close the deal (get a high price).
• You (The Owner): Incentivized to justify your purchase.

Always ask: "What does the person who built this model have to gain?"