Discounted Cash Flow Method and Forecast Assumptions

This just in - financial statement forecasts / projections are key to a reliable valuation using the discounted cash flows method (DCF).  My first reaction is, "Wow that is mind-blowing."  It must be true because the highly-regarded Delaware Chancery Court ruled on it in S. Muoio & Co v. Hallmark Entertainment Investments.

In the case at hand, the expert puffed up or, as I like to say O'Learyed (see O'Leary, George, Notre Dame head football coach for one week), the management forecast in order to derive a higher value.

In all seriousness, forecasted earnings and the assumptions on which they are prepared are the cornerstones for reliable estimates of value when using DCF.  From my viewpoint, DCF is appropriate only when future earnings or cash flow will significantly exceed the long-term sustainable growth rate, which is generally measured based on inflation rates.  As such, start-ups and emerging technology enterprises are likely candidates for DCF.  However, some very well-regarded valuation analysts live and die by DCF.  Theoretically, DCF can be used in all valuation engagements.

DCF is driven by assumptions.  Bad assumptions will give unreliable estimates of value.  This makes some courts wary of the method.  If management wants a higher value, they will use aggressively optimistic assumptions in their forecasts.  So the caveat is: pound on the assumptions.  Perform due diligence.  How accurate has management been in their previous forecasts or budgets?  Is it really reasonable that the future will be better than the immediate past has been?  Beware of the industry operating cycle and know where the subject company is with regard to the cycle.  If the cycle is 3 years up followed by 3 flat years, make sure the plateau is incorporated into the forecast.

Valuation analysts are paid for their analysis and observations.  More importantly, they are paid to give appropriate wait to their observations as they affect value.  Be careful out there; and, when using DCF, trust but verify.

Be Safe Out There

This weeks edition contains a couple of warnings to help you stay safe.  Earlier this week, I spoke at Mississippi State University's Insurance Day on the topic of ethics.  Ethics is a broad topic, so I spoke on one of my favorite topics, fraud.  Most people do not fail ethically because they cannot determine the difference between right and wrong, they fail because they want the benefit to be gained by doing wrong.  (As I freely admit, I would have no problem with sin if it did not look like fun).

A couple of attendees approached me after the session with their stories.  Their losses were caused by misplaced faith.  As Ronald Reagan said, "Trust but verify!" The simplest and most effective fraud deterrent is for the small business owner to receive the bank statements unopened and review canceled checks. Review for reasonableness of payee, amount, and timing. Occasionally follow up with your personnel to let them know that you are looking.

My second caveat relates to the valuation of start-up or high-growth companies.  In most cases involving such companies, the business valuator relies on the discounted future cash-flow method.  Under these circumstances, the valuator must challenge the assumptions which underly the forecast, which are generally provided by the owner of the company, if said owner does not prepare the forecast.  As you may expect, we often encounter the following circumstances:

• Unrealistic revenue growth, both in terms of rate and duration.
• Growth in expenses at the CPI rate of inflation.
• Over-valuing of a patent or patent application.
• Overstated benefit of synergies.

Generally, crunching the numbers in such a valuation is straight-forward.  An analyst needs to earn his/her keep by determining whether the key assumptions are reasonable and by assessing the effect of small deviations in the forecast.

One final caution on patents.  Patents are relatively cheap to obtain.  Enforcing them is very costly - consider a ballpark figure of $7 million per case.  Statistics indicate that half of all patents have NO strategic value.  Only 2-5% of patents generate any royalties.

Keep your eyes open.  As Yogi Berra says, "You can observe a lot just by watching."