Should you Review a Company’s Projections or Not?

If you use a company’s internally developed projections when developing a discounted cash flow estimate of value, what are the real risks?

This article offers a practical guide to using a company’s budget and plan for utilizing future projections in a discounted cash flow calculation.

When a business valuator requests and reviews a company’s budget for the current and future years, how much of the data should be reviewed to determine its credibility and reliability?   It is generally understood that the valuation advisor will not be attesting to the data in these documents, yet it is  critical that the analyst examine the underlying assumptions, data, and information provided before adopting these internally developed assumptions.

One of the many issues that a business appraiser needs to consider is whether management  had previously developed a strategy that is clearly reflected in the projections, before they were adopted.  As an experienced business appraiser knows, it is not adequate to just look at the long-range plan projections; the professional advisor has to examine the detail and materials that comprise the basis for the projections developed.

In anticipation of reviewing any such projection, management should be asked a series of questions; management should also be prepared to answer these questions.  The questions raised can be roughly broken down into several areas.  Those areas include: industry comparison, competitive assessment, the company’s strategy and priorities for the future, and how it develops its top-line growth goals.  

1. Industry Comparison

1. What analyses were made by the company as to their position in the industry—city, state, regional, national, and international? 
2. Does the company possess significant strengths or weaknesses that position it to be a leader or follower in the markets it serves?
3. By examining the answers to these questions, one will learn if the basis for the future revenue performance of the company is realistically achievable.  Based on the competition answers, management will (ideally) gain an insight as to the reasonableness of its profit projections  and one can begin assessing the merits of the projections.

2. Company’s Competitive Assessment

1. What are the strengths of company personnel compared to other businesses in the industry? (When a business is growing, one of the greatest risks is that it will outstretch its management capabilities.  For example, if significant growth is forecasted in the next three years, does the company have either plans or the ability to train, attract, or recruit the professionals it will need as the business volume changes?)
2. What is unique about the company’s organization that differentiates it from other companies in the industry?  (If a company is unable to differentiate itself in its industry and market(s), how does it expect to maintain its percentage of the market or even grow in the future?)
3. What systems and procedures are unique to the company compared to other firms in the industry?  (This answer details how well the company knows its competitors and what systems or procedures it may have that are unique that set it apart from those establishments.)
4. What products or services differentiate the subject company from others in the industry?  (This question will identify areas where the company has opportunity to grow without having to take business from a competitor.)
5. What plant or tangible assets does the company possess that differentiate it from other businesses in the industry?  (Depending on the industry the company operates in, physical assets can have a significant impact on the ability of the business to sustain growth, or it may need additional capital to achieve an increase in volume.)

3. Strategy or Priorities for the Company’s  Future and Performance

1. What are the characteristics that help customers choose one business over another in the industry?  (Being recognized in its industry for a specific quality provides a business the opportunity to expand its customer bases either in the current market(s) that it is serving or expand into other markets.  Based on some of the other factors that have been gleaned from the prior questions, this will provide guidance about the feasibility of achieving budget goals, and that the data provided to the appraiser can be realized.  That said, technological innovation and changes in consumer preferences can disrupt the industry and value of the brand, as evidenced by RIM’s Blackberry and Dell erosion of market share.)
2. Who are the targeted competitors, and what size and strengths do they possess?  (Knowing the competitors of a business and having analyses of their strengths and weaknesses provide the business insight into market opportunities that exist due to the uniqueness of the company being appraised.)
3. How does the company plan to exploit its strengths to capture more of the competitors’ market share?  (Being in an industry where take away is necessary for growth, the company needs to present an approach that will enable it to capture the competitors’ customers.  A history of being successful in this endeavor is critical to assume that it a realistic and achievable goal.)
4. What are the risks to achieving the company’s future performance?  (After seeking answers to the detailed questions, it is necessary for the appraiser to interview management on the probability of achieving the sales objectives based on the historical performance of the company, compared to the sales budget for that year.)

4. How Does the Company Develop its Top-Line Growth Goals?

1. Is growth strategy based on organic growth?
   1. Does the company have a cost strategy compared to the competition?  (Price lists and marketing information should provide these answers.)
   2. Does the company have the ability to differentiate itself from the competition?
   3. What is the company’s customer retention rate?  (This will provide an insight about what is unique about the company.)
   4. Does the company have a technology advantage?   (This may be a question that is applicable for some industries.)
   5. Does the company have personnel with a skillset that is stronger than the competition?  (Is the company experiencing management personnel turnover higher or lower than the industry average?)
2. Is growth predicated on making an acquisition?
   1. Has the company successfully made acquisitions in the past?  (Asking this question often leads to a discussion about pending actions  the company is considering .)
   2. Does the company have established criteria about the basis for pursuing an acquisition?  (This question often leads to the revelation of either no criteria or a written criterion that is being developed as a method to grow the company.)
   3. Is there a valuation criteria definition about acquisition candidates?  (The size of target companies for an acquisition needs to be explored in order to determine a likely candidate.)When would be the best time to undertake the closing on an acquisition?  (Timing often dictates acquisition.) 
   4. How large of an acquisition can the businesses reasonably expect to absorb with its current management team and staff?
3. Who is leading the company’s goal-setting initiative, and how are they tracking its results and implementation?
   1. What has the company explored when looking to expand?  (Is the expansion plan based on vertical or horizontal growth?)
   2. How specific are the criteria for a prospective company to be considered for a potential acquisition?  (The more specific the criteria, the more likely  the company will not waste time, money, and energy pursuing an opportunity that is not a good fit.)

5. What growth strategy does the company employ?

1. How much growth in the budget is based on external actions over which the company has no direct management control?  (This answer helps to test the reality of the growth achievability in the budget provided the appraiser.)
2. How much growth in the budget is based on organic growth?  (What has been the historic growth rate based on no acquisition?)
3. How does the organic growth budgeted by the company compare to the prior year’s organic growth? (Is organic growth percentage realistic compared to the historical performance of the business?)

6. Past Budget Execution

1. How has the company performed in prior years compared to the budget for that year?  (This answer provides insight into the probability that the forecast provided is realistic.)
2. How has the company performed in prior years compared to their long-range plan?  (If a multi-year plan has been developed in the past, how has the company performed over multiple years of the plan?)
3. What critical personnel have turned over during the past three years?  (A business is often limited in its growth by the lack of skilled personnel.  Does the company have adequate trained personnel to allow it to grow to the level the forecast is indicating?)

Based on the application of these questions about a forecast, budget, or long-range plan that is being provided to the appraiser, acceptance of what is provided should not be automatic.  Utilizing questioning as present above will provide guidance to the appraiser about how realistic the data being given is and how much reliability should be placed on it.  If questions are not fully answered or the answers are either not realistic or consistent, then the valuation professional will have a number of hard choices to make.

Ed Wandtke, MBA, CPA, CVA, is a business valuation professional who specializes in intellectual property, intangible assets, service companies, and estate and tax valuations.  Mr. Wandtke can be reached at (614)579-6510 and/or Ed.Wandtke@wandtke.com.