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.
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