The Income Approach to business valuation is based on the principle that the fair market value of an entity may be measured by the present value of its future cash flows. In order for a valuation analyst to prepare a supportable valuation under the Income Approach, it is important for management to provide cash flow forecasts developed by individuals with an intimate understanding of the business using well-supported assumptions. Although it is the responsibility of the subject company’s management to forecast future cash flows for the company, the valuation analyst must maintain a healthy level of professional skepticism when utilizing such forecasts. For example, if sales and earnings have grown over the past five years and the forecasts provided by the company’s management indicate that sales and earnings will decline over the next five years, management should be able to explain the factors causing the shift. There may be a simple explanation that makes sense given expected changes to the company and the market in which it operates, but if no support is available, it might make sense to consider adjusting the forecasts.
Are the forecasts overly optimistic or overly pessimistic? Providing historical budget to actual comparisons is one simple way to help the analyst understand the company’s forecasting strategy. If budgets are consistently much lower or higher than actual results, it might be difficult to rely on the current forecasts. On the other hand, if historical budgets were relatively in-line with actual historical results, the recent forecasts may gain some reliability. Management should discuss consistently missed budget targets with the analyst in case the forecast methodology has changed and/or a new individual is preparing the forecasts.
When reliable forecasts are utilized in the Income Approach to business valuation, a stronger and more supportable valuation will be developed. The valuation analyst can work with management to help ensure that reliable forecasts are prepared.
Schneider Downs has extensive experience performing business valuations and analyzing sales, earnings and cash flow forecasts for its clients. For more information about reliable forecasting or Schneider Downs' business valuation and other business advisory services, please contact Joel Rosenthal at 412.697.5387.