Today, I want to spend some time discussing an aspect of the business valuation industry that is near and dear to all our hearts but is also subject to quite a bit of controversy amongst ourselves.\u00a0 To begin, I want to share a small quote from the Internal Revenue Service\u2019s Revenue Ruling 59-60, just to make sure we are all on the same page.<\/p>\n
\u201cValuation of securities is, in essence, a prophecy as to the future and must be based on facts available at the required date of the appraisal.\u201d\u00a0 RR 59-60, Sec. 3.03<\/p>\n
Said another way, the value of a business is based on its expected future earnings.\u00a0 This means that every business appraisal includes a\u00a0projection<\/em>\u00a0of the future, regardless of whether or not one is using a discounted cash flow method or a capitalization of earnings method.\u00a0 Business appraisers are deriving our opinions as to the value of a business based on what we think the future of the subject business will look like.\u00a0 Unfortunately, when I began in this industry over 20 years ago, I was not issued a crystal ball to assist with my determination of the future.<\/p>\n I had to add some emphasis on the word, \u2018Projection\u2019 in that previous paragraph because that word is part of the controversy I mentioned earlier.\u00a0 I am one of those appraisers who use the two terms, \u2018Forecast\u2019 and \u2018Projection\u2019 interchangeably, as I do not see a difference between the two phrases.\u00a0 However, there are other differences of opinion on the matter and after you have spent some time in the Business Valuation (BV) industry, you will see that differences of opinion are common, but what is important is an appraiser\u2019s ability to explain and defend their individual position.<\/p>\n So here goes my explanation of my position:<\/p>\n According to the American Institute of Certified Public Accountants, the definitions of \u2018Forecast\u2019 and \u2018Projection\u2019 have different meanings.<\/p>\n Both of these definitions incorporate the phrase, \u2018expected financial position\u2026\u2019, but the Financial Projection definition also includes the word, \u2018Hypothetical\u2019 and adds the question, \u201cWhat would happen if\u2026?\u201d\u00a0 I posit that the question, \u201cWhat would happen if\u2026?\u201d is answered in every business appraisal where any number of assumptions are cited, including any assumption of continued operation or future growth.<\/p>\n I googled the definition of \u2018Hypothetical\u2019, and the following was provided:<\/p>\n (Also, please remember that the definition of \u2018Fair Market Value\u2019 itself includes specific hypothetical assumptions.)<\/p>\n So, if I understand the AICPA\u2019s definition of a \u2018Financial Forecast\u2019 correctly, a Financial Forecast is a prospective financial statement that reflects the conditions that are expected to exist going forward, and \u2018expected to exist\u2019 means that these conditions are not actually in existence as of the effective date of the valuation.\u00a0 If a condition does not yet exist, might its eventual existence be considered a hypothetical assumption?<\/p>\n In other words, those conditions are, \u2018supposed but not necessarily real or true\u2019?\u00a0 One of these conditions might be the assumption that the business will continue as a going concern.\u00a0 Another assumption might be that the business will continue to grow annually at a similar rate to what has been seen historically.\u00a0 These are fairly basic assumptions that most of us have used throughout our valuation practice, but I just want to point out that these are still hypotheticals as the future cannot be proven to exist or be guaranteed to occur.<\/p>\n Let\u2019s explore these hypothetical assumptions in light of current events like the advent of COVID-19.\u00a0 As of this writing, we have seen some of the economic impact COVID-19 has had on small businesses, however, the annual historical financial information we are provided will not include any of that economic impact.\u00a0 An analysis of historical trends may NOT be of use to us in the valuation of many businesses as their future operations may have been dramatically affected.\u00a0 Can we apply those two common assumptions mentioned above and that we have likely used in most of our prior valuation engagements and blindly apply them now?\u00a0 Will the subject business see annual growth in 2020 and 2021 similar to what was seen in 2019, 2018, and 2017?\u00a0 Will the subject business remain a going concern and survive the economic impact of the events of the year 2020?<\/p>\n This means that the \u2018prophecy as to the future\u2019 described in RR 59-60 likely will NOT be reflected in one of the most commonly used methods of arriving at a financial forecast; that of a weighting of historical results.<\/p>\n The most common method I have seen used to determine a prophecy as to the future, while still relying on facts available as of the required date of the appraisal is the historical weighting technique where the appraiser decides which of the last few time periods\u2019 results are more applicable and assigns a greater weighting to those years.\u00a0 One of the more common weightings I see is the 5, 4, 3, 2, 1 weightings over the past five years with the most weight being placed in the most recent year.\u00a0 Since the last five years of data do NOT include any of the economic impacts of COVID-19, the appraiser who is still using that technique today maybe incorporating some extraordinary assumptions, instead of merely hypothetical ones.<\/p>\n Another area of controversy is who is supposed to develop those Financial Forecasts\/Projections that business appraisers use to value a business?\u00a0 I will always ask the client for any forecasts, budgets, or anything else that may have been prepared in-house for predicting the future.\u00a0 Most of the time, the business owner\/client tells me that they do not prepare any such thing and frankly don\u2019t have the time to do so.<\/p>\n Some business appraisers I have talked with over the years tell me that even if management does not prepare forecasts on a regular basis, they will still insist that management participates in the creation of those projections in some way or another.\u00a0 Some appraisers insist on being provided with a forecast.\u00a0 Others will rough out a projection and then ask management to bless it.\u00a0 Still, others feel perfectly comfortable creating the whole forecast and will occasionally ask management to review it.<\/p>\n The biggest concern I have heard expressed about that third group, the one that creates their own forecasts, is that many appraisers feel that concluding to an opinion of value while relying on the forecast opinion they also created, seems somehow incestuous and unreliable.<\/p>\n Personally, I\u2019m in that third group, for a variety of reasons, two of which are as follows:<\/p>\n First, I have quite a bit more experience than management likely has in creating a forecast.\u00a0 I have already researched the applicable economic and industry outlooks as part of the valuation process.\u00a0 I have analyzed the historical financial statements and have interviewed management about what conditions they expect to realize in the future, and best of all, I\u2019m an independent expert so I do not have any agenda or reason to influence the conclusion of value either way.<\/p>\n Second, under USPAP Standard 10-3b it says the following:<\/p>\n \u201cIn an assignment that includes only assignment results developed by the business and\/or intangible asset appraiser(s), any appraiser who signs a certification accepts full responsibility for all elements of the certification, for the assignment results, and for the contents of the appraisal report.\u201c<\/p>\n This bit of text seems to say that whatever forecast or projection I use in my report, once I sign the certification, I claim responsibility for every decision and assumption utilized in the development of that forecast.<\/p>\n I have been provided with Financial Forecasts from management where they show the business, that up to now has been growing steadily, will now be expected to lose a key customer and its major supplier has advised them that the cost to import raw materials will be doubling every year for the next several years.<\/p>\n I have also been provided with a forecast that showed almost exponential revenue growth over the next five years, with almost no corresponding increase in costs or expenses.\u00a0 (Which brings up a point, why do most forecasts seem to always go out exactly five years?)<\/p>\n Neither of these two scenarios was ever anything I considered likely, and I had no problem discussing the forecasts that were provided to me and why I did not rely on them, preferring instead to create my own projection\/forecast.<\/p>\n I believe that if I am going to sign a report, I need to believe everything that is in there and the most trustworthy person I know to develop a forecast is myself.\u00a0 I\u2019m already going to be selecting which methods are most applicable, the magnitude of the specific company risk premium, which equity risk premium I should use, how I\u2019m going to support the various normalization adjustments I am making, deciding on the most likely long-term sustainable growth rate to use, selecting the market transaction data to incorporate, selecting the market multiple to use, analyzing and determining the size of an applicable discount for lack of control and\/or marketability, and even whether or not to round my value conclusion.\u00a0 So why not build a forecast that I actually believe is a reasonable approximation of the expected future results, instead of relying on management\u2019s forecast.\u00a0 I\u2019m being paid to provide my opinion after all, and not management\u2019s.<\/p>\n True, I do not have a crystal ball that can tell me what the future holds, but as of the effective date, I have access to lots of information that can assist me in determining what a likely version of the future could be.\u00a0 I will guarantee to anyone who is curious, that every single forecast I have ever worked on was most likely wrong.\u00a0 I don\u2019t, and can\u2019t, know what the future holds, but I can provide a reasonable estimate that both a hypothetical willing and able buyer and willing and able seller, with no compulsion to buy or sell, each party having reasonable knowledge of relevant facts might agree on and use that to arrive at my value conclusion.<\/p>\n TLDR Version: Every single business appraisal includes a forecast. Make sure, if you are the appraiser, that you really do agree with the projection you are relying on.<\/strong><\/p>\n Recommended Reading<\/b><\/span><\/p>\n <\/p>\n Recommended Resources<\/b><\/span><\/p>\n Recommended Courses<\/b><\/span><\/p>\n ISBA Learning<\/b><\/a><\/span>:<\/b>\u00a0Looking for authoritative business appraisal courses, tools, webinars, and more? Stop trying to create resources from scratch and start taking advantage of having exactly what you need right at your fingertips in\u00a0ISBA Learning<\/span><\/a>.<\/span><\/p>\n","protected":false},"excerpt":{"rendered":" Today, I want to spend some time discussing an aspect […]<\/p>\n","protected":false},"author":12,"featured_media":10444,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[37,42,30],"tags":[],"class_list":["post-10443","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-business","category-covid-19","category-general-blog"],"yoast_head":"\n\n
\n
\n
\n
\n
\n