For an operating company, the income approach often provides the best indication of value to rely upon, because it reflects the cash flow expectations specific to the company. The income approach, specifically a discounted cash flow analysis (“DCF”), captures the value of a company’s future expectancy by discounting a company’s projected operating cash flows by a discount rate to yield a price that investors would be willing to pay for the indicated cash flow stream. As such, management’s projections are a key factor in determining the integrity and veracity of the indication of value resulting from the income approach.
The valuation community relies on the income approach as a primary method in determining the value of a company because, in most cases, publicly traded companies are too big with more diversified operations and guideline merger and acquisition transaction details are often limited. Projections and the underlying assumptions contained therein are discussed in the management interview. The management interview is an important step in the valuation process, as it is an opportunity for the management team to explain and justify the projections to the appraiser. Management should be prepared to answer the following questions about their projections:
- What is the company’s current order backlog and how does it compare to prior years? What does it say about the current near term outlook?
- Are there any pending sales or project proposals outstanding that have not yet been awarded to the Company, but which could have a major impact on its results if awarded?
- How were the company’s projections prepared and with input from whom?
When developing projections, management should consider the following factors as a beginning point in developing company forecasts:
- Percentage growth by year
- Unit volume growth by year by product line
- Changes in unit prices by year by product line.
- Large or unusual factors contributing to future revenues.
- Likelihood of achieving forecast.
- Breakdown of anticipated growth between growth of market in total and Company’s growth in market share.
- Gross profit margin percentage trends by year overall and by product.
- Comparison to past actual performance.
- Which line items represent fixed and/or semi-fixed costs.
- Which line items represent variable costs.
Tax Rate Changes
Capital Expenditures (Capex):
- Maintenance capex vs. Growth capex.
- Method of funding expenditures (internally or externally).
- How far (revenues) Company can go with current physical capacity? Amount of excess capacity?
There are many common pitfalls in management projections:
- Projected revenue growth and profit margins exceed the Company’s historical performance or margins far exceed those achievable by the comparable peer group (aka: the industry, the marketplace);
- Closely-held businesses include expenses unrelated to the operations of the company (i.e. business owners personal expenses and salaries paid to family members who are not active in the business);
- Projected operating expenses and capital outlays don’t reflect levels to support the ongoing operations of the Company (i.e. business owners underpay themselves, computer equipment and software has not been updated, manufacturing equipment is dated and fully depreciated).
- Management projects depreciation expense outpaces expected capital maintenance requirements, or put more simply management is projecting its fixed asset base will deteriorate without additional capital spent to maintain or update the assets; and
- Projected net working capital requirements are significantly below that of industry peers.
When faced with projections that are out of line with past performance, Quist can make the following adjustments. First, we can reflect the risk of the Company achieving the projections provided by management by applying either a higher discount rate (if projections are “aggressive” relative to past performance) or lower discount rate (if projections are “conservative” relative to past performance) on the future projected cash flow streams. Second, we may run multiple scenarios (low-case, mid-case, and high case) and weight the resulting indications of value based on an assessment of the primary assumptions driving each scenario. Quist’s ability to run sensitivity analysis around a multitude of factors (i.e. revenue growth, margin, profit growth, etc.) helps us to understand where the primary risks are around management execution.
Good financial projections are a key piece to performing the income approach and arriving at a supportable and believable valuation conclusion. When creating projections, it is important for management to understand the underlying assumptions contained within each section of the company’s forecast. In addition, it is important that management clearly articulate how they arrived at their projected figures and how they plan to achieve the forecast, especially in regards to how the company has performed historically. A good understanding of this information will allow a management team to confidently explain how the company will address each assumption and make it a reality.