Nailing Down the Numerator in the DCF Method

Theory to Practice VPS StraightTalk Webinar, June 15, 2023

This article summarizes key takeaways from the June 15, 2023, VPS StraightTalk Webinar presentation co-led by R. James Alerding, CPA, ABV and Carli D. Lehr, CPA, CVA, CSEP. The speakers discussed how to differentiate between a projection and forecast, the importance of developing a reliable cash flow or projection evaluation of specific risk to the overall valuation, lessons from court cases regarding the use of forecasts, and what valuation standards say about the use of prospective financial information in business valuations. This article summarizes key points.

Business valuation analysts spend a considerable amount of time discussing discount and growth rates. In industry parlance, this is referred to as discussing the denominator. In this webinar, co-led by R. James Alerding, CPA, ABV and Carli D. Lehr, CPA, CVA, CSEP, the two webinar speakers discussed how to differentiate between a projection and forecast, the importance of developing a reliable cash flow or projection evaluation of specific risk to the overall valuation, lessons from court cases regarding the use of forecasts, and what valuation standards say about the use of prospective financial information in business valuations. This article summarizes key points.

The simplest definition of the value of an investment is the present value of the future cash flows generated by that investment. Business valuation analysts will use net income, income before tax, income before depreciation, interest, and taxes, or a cash flow measure. Regardless of the numerator used, valuation analysts must have a basis to develop the numerator. Damodaran opines that:

When our valuations go awry, it is almost never because of mistakes that you made on the discount rate, and almost always because of errors in your estimates of cash flow (with growth, margins, and reinvestment).

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Spend less time on estimating discount rates: it follows then that when you have a limited amount of time that you can spend on a valuation, that time is better spent on assessing cash flows than on fine tuning the discount rate.

Cash flow does not always grow at a fixed rate. Such an assumption is suspect. Businesses grow and contract. Monte Carlo modeling is gradually being used to model probabilities of upturns and downturns. But to develop and properly use any such risk-adjusted modeling, practitioners must understand a company’s management, industry, business model, and company’s financial history.

Cash Flow Basics in the Income Approach

1. Capitalization of Cash Flow Method (CCF)

Is this method appropriate? It may be appropriate if a single period of cash flow is representative of an average annual return in perpetuity. CCF is a terminal year DCF that assumes a consistent growth rate.

While there is apparent simplicity using this approach, that is deceiving. Valuation analysts must determine the number of years of historical cash flows to include in the analysis, whether to weigh or unweigh the historical cash flows, exclude certain years, understand industry and economic outlooks, consider the impact of COVID-19 on the financials. Further, it is critical to understand the CAPEX, depreciation, income taxes, and working capital adjustments. These are not easy judgment calls. These factors require that the business valuation analysts interview management, visit the site, and ask detailed questions to understand how the leadership has responded to growth opportunities and threats.

2. Discounted Cash Flow (DCF)

DCF is a multi-period method of valuation. The DCF equation includes the present value of future cash flows for a period of inconsistent growth plus the present value of the terminal value of the business calculated using once consistent growth is expected in the future. Use DCF where variable future growth rates are expected. Use it when variation in future cost structures are expected, where large capital improvements are expected (for example, such as a result of increased capacity), and revenue and expense changes are expected or knowable.

The usual excuses listed by the speakers for using CCF over DCF are the following:

• Management does not know the future
• Management does not have projections or forecasts
• The valuation analyst(s) wants to avoid using a set forecast given the uncertainties
• There are too many moving pieces to say how things will “go”
• The company should be valued as of “now” (the valuation date), not in the future
• How does one know how far to project future cash flows until the terminal year

These are valid but surmountable points. The speakers addressed these concerns in detail and fielded questions from attendees. (At this juncture, we refrain from going into detail since QuickRead’s summary is not going to provide that level of detail; to hear the detailed response, readers are encouraged to subscribe to the VPS StraightTalk series or subscribe to the recoding.)

3. Professional Standards

Management may or may not develop forecasts. There is guidance on what to do in both instances.

If management has developed forecasts, then exercise (as Mark O. Smith, JD, CPA, stated in the AICPA Insights, February 28, 2017, blog post, Fair Value Measurement Valuation) healthy skepticism. Citing Smith, practitioners must understand and document how the prospective financial information (PFI) was developed by management. It is important to understand the purpose for which the PFI was developed and whether the PFI was developed using market participant assumptions. Part of the valuation professional’s responsibility is to evaluate the PFI provided by management for reasonableness in general, as well as specific areas. The failure to conduct due diligence here can lead to a valuation conclusion that misses the mark by a wide margin.

As for standards, ASA, Business Valuation Committee Special Topics Paper #3—The Use of Management’s Prospective Financial Information cautions that “for a business valuation analyst to objectively perform the valuation analysis, the analyst has to judge whether or not management’s prospective financial information is reasonable and can be relied upon in the valuation analysis.” Standards BVS-VIII: Comprehensive Written Business Valuation Report broadly specifies that “[i]f projections of balance sheets or income statements are used in the valuation, key assumptions underlying those projections must be included and discussed.” Business Valuation Committee Special Topics Paper #3—The Use of Management’s Prospective Financial Information by a valuation analyst cautions analysts here. Forecasts that are suspect are not useful. Such forecasts cannot be used. If a selling owner or company CFO has developed glorious projections that are not based on facts or realities besetting the industry and/or company, then they should revise the same. Again, doing this requires that the analyst understand the company and industry.

The latter source recognizes that many small businesses do not develop forecasts and/or may not have staff to develop forecasts. What should one do? Here too, there was a fair amount of discussion and advice. The forecast has to be management’s, not that of the analyst. This means that an analyst may want to consider not taking the engagement; discussing fees earned to date when it is apparent management wants you to develop a forecast is fraught with danger. Be careful, be judicious.

AICPA Statement on Standards for Valuation Services VS Section 9100, Section 80, List of Assumptions and Limiting Conditions that provides cautionary and disclaimer language will not necessarily immunize an analyst that uses management’s forecast(s). VS Section 9100 Valuation Services Interpretations of Section 100, Sections 74 and 75 includes Illustration 22 that similarly “require[s] the valuation analyst to examine and compile such information in accordance with Statements on Standards for Attestation Engagements (SSAEs).

4. Forecasts vs. Projections

There is a distinction between these two terms; the best practice here is to use management’s prepared forecasts. AT Section 301 defines the terms as follows:

Financial Projection: Prospective financial statements that present, to the best of the responsible party’s knowledge and belief, given one or more hypothetical assumptions, an entity’s expected position, results of operations, and cash flows.

Financial Forecast: Prospective financial statements that present, to the best of the responsible party’s knowledge and belief, an entity’s expected financial position, results of operations, and cash flows. A financial forecast is based on the responsible party’s assumptions reflecting the conditions it expects to exist and the course of action it expects to take.

Projections can be used in some limited situations. Those include pricing real options where different scenarios are considered and weighed, best/worst/expected scenarios are developed, and whether future income will not look like historical income because of changes in the nature of the business.

5. Legal Considerations—Some Case Law

Fish v. Greatbanc Trust Co. is instructive on the points raised by the speakers. This is an ESOP case that involved allegations of breach of fiduciary duty and engaging in prohibited transactions. The decision turned on whether the ESOP trustee’s financial advisor had performed proper due diligence and issued a defensible fairness and valuation analysis. At trial, the experts reached sharply different assessments of the work. The trial court found the defense expert’s testimony validated the advisor’s work and that “no more than fair market value was paid for the non-ESOP shareholders’ stock.”

Another case discussed in detail was Lund v. Lund, 27-cv-14-20058 (District Court, Fourth Judicial District, Hennepin County, Minnesota) (June 2, 2017). The case involved a court-ordered buyout. A key issue there was whether Plaintiff’s expert presented an “overly optimistic.” The takeaway in this case is that Lund provides an excellent example of how to prepare a budget.

PetSmart Inc., 2017 Del. Ch. Lexis 89 (May 26. 2017) was another case discussed. The case involved a statutory appraisal.

6. Review of Prospective Financial Information (PFI)

The key questions here are “who is providing the forecasts” and what is the skill level of the person preparing these? One also has to ask him/herself whether management is motivated to skew the forecast and the purpose of the engagement.

Again, there are a host of industry sources and economic data that analysts should be familiar with and consult.

As for forecasts, the following items need to be addressed by analysts reviewing PFIs and the integrity of the same:

Income Statement Items

• Revenues (issues ranging from customer concentration to customer turnover to competitor composition, non-recurring items, production capacity, and pricing and volume changes)
• Cost of goods sold—materials
• Cost of goods sold—labor
• Fixed expenses

Balance Sheet Items

• Accounts receivables changes and their correlation with revenue changes
• Percentage completion schedule
• Accounts payable
• Accruals
• Working capital changes
• Level of equity changes
• Level of debt changes

The PFI should tell a story and make sense.

In the latter part of this webinar, the speakers provided a hypothetical and discussed to illustrate the points made above, along with a valuation.

The speakers concluded the presentation cautioning analysts about preparing a PFI where none has been provided by management. If a valuation analyst does prepare the PFI, that should be priced and be defensible.

Conclusion

If the forecast is not viable, then the valuation is not viable, regardless of the discount. Once the valuation analyst has concluded their analysis and review of the forecast, they should take another look at the results and determine whether they make sense on the whole. If there is doubt, then use multiple forecasts to determine a value (ranges are allowed under any of the BV standards) or adjust the discount rate for the specific risk observed in the forecast. Adjusting the cost of capital is “risky” by itself because there are already so many factors that go into the determination of the discount rate and there are no set benchmarks to quantify that option.

This webinar should be a review for experienced practitioners; newer or mid-level practitioners that are preparing to go in to the “field” will benefit from the insight provided by the speakers in this VPS StraightTalk webinar. QuickRead readers can visit VPS to order the webinar, obtain the handouts, and listen to these two seasoned speakers.

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Roberto H Castro, JD, MBA, MST, CVA, is a retired attorney, now focusing on litigation support. He is also Technical Editor of QuickRead and a member of NACVA’s CUV team.

Mr. Castro can be contacted at (509) 679-3668 or by e-mail to rcastro@rcastrolaw.com.