During my over two decades of working in the valuation profession, I have valued several hundred entities and reviewed hundreds of valuation reports, including business valuation calculation reports, summary reports, and comprehensive valuation reports prepared by other experts.
While I have only infrequently seen valuation theory applied incorrectly, I routinely have seen business appraisers make assumptions in a valuation that could be considered illogical disconnects within the valuation at best—and outright errors at worst.
Several of these assumptions may be found within the forecast of future cash flows used in the income approach. Business appraisers must often deal with financial forecasts in their valuation of private companies. In many cases, management of the company being valued will provide financial forecasts or projections to an appraiser to be used in a discounted or capitalized cash flow model.
Appraisers preparing a calculation report, summary report, or comprehensive valuation report might:
- accept these forecasts at face value because management prepared them
- tweak the forecasts based on the appraiser’s judgement
- come up with their own forecasts of the company’s cash flow
Regardless of which forecast an appraiser relies upon, there will be several assumptions within that forecast that must be adequately analyzed and supported, or the effect could be overvaluation or undervaluation of a company.
While there are many assumptions used by an appraiser in a valuation, the assumptions I will focus on for this blog series are forecasts of:
- capital expenditures, depreciation, and amortization
- working capital to sales
- short and long term growth rates
- use of future debt
These ratios and assumptions are embedded in the forecasted cash flows an appraiser uses in capitalized cash flow or discounted cash flow model A model of capitalized cash flow or discounted cash flow may be theoretically and mathematically correct, yet not provide a reasonable value due to unreasonable or unsustainable assumptions.
This is the first in a series of blog posts on assumptions made in cash flow forecasts. In coming posts, I will point out several issues I have observed in my review of cash flow forecasts in business valuation calculation reports, summary reports, and comprehensive valuation reports and valuation models.
In the meantime, if you are interested in learning more about how you can strengthen your case with a business valuation expert or want to learn more about our services and our team, please contact us.