Often, business valuations are based on estimates of expected cash flow made by the company’s management. Even when a business valuation expert or the company’s CPA prepares the estimate, it’s often based on management’s representations about the company’s future plans about market opportunities and potential threats. So, it’s important to evaluate whether expected cash flow seems reasonable — or whether the estimate is overly optimistic or pessimistic.
Fundamental building block
Suppose a business valuation expert has two recent estimates of net cash flow to choose from:
If a valuator applies a 20% equity capitalization rate to both estimates, the resulting values would be $25 million ($5 million divided by 20%) and $20 million ($4 million divided by 20%). In other words, if the valuator uses the projection rather than the forecast, every $1 of additional net cash flow results in an extra $5 of value at a 20% cap rate.
Forecast vs. projection
Which of these two hypothetical estimates is appropriate? When evaluating cash flow estimates, it’s important to understand the difference between the terms “forecast” and “projection.”
The AICPA defines forecasts as prospective financial statements that present, to the best of management’s knowledge and belief, an entity’s expected financial position, results of operations and cash flows. A financial forecast is based on assumptions reflecting the conditions management expects to exist and the course of action management expects to take.
It defines projections as prospective financial statements that present, to the best of management’s knowledge and belief, given one or more hypothetical assumptions, an entity’s expected financial position, results of operations and cash flows. Projections may present a hypothetical course of action for evaluation.
Valuators generally use forecasts — that is, expected results based on the expected course of action — when appraising private business investments. Projections are sometimes used, however, when calculating economic damages, determining fair value in a shareholder dispute or evaluating capital budgeting decisions. The date of and reason for preparing the estimate also can impact its relevance.
Name that estimate
It’s perfectly acceptable for valuators to rely on an estimate of expected cash flow that’s prepared by the company’s management. But it’s important to understand the type of estimate that was created. Small differences in expected cash flow can have a big impact on the value of a business.
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