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Forecasting Considerations and Techniques print this article

Introduction

Another important, challenging and dynamic area of professional business valuation concerns forecasting methods related to both the income statement and the balance sheet.  The most obvious need for forecasting skills involves the application of discounted cash flow analysis, whereby the valuator must project multiple account balances several years into the future.  Basic business valuation principles, modern financial theory and the most influential valuation-related contribution ever made by the Internal Revenue Service highlight the importance of forecasted financial performance.

According to Ray Miles’ Basic Business Appraisal, the “principle of future benefits” holds that “economic value reflects anticipated future benefits”.  Or, as Justice Oliver Wendell Holmes noted, “All values are anticipations of the future”.  The IRS has also made clear the importance of future performance and therefore forecasting through one of the most well known valuation-related quotes in the profession today, namely “Valuation is a prophecy as to the future” (Revenue Ruling 59-60).  In addition, modern financial theory as preached around the globe today is premised almost entirely on the “time value of money” principle.  Simply stated, the value of any asset is a function of the future net cash flows accruing to its owner(s).

Ray Miles puts “the future” in perspective by reminding readers that “one of the most difficult parts of the task of appraising is to arrive at reasonable estimates of future circumstances and performance, without which the appraiser cannot be confident of the validity of his or her results”.  Dr. Shannon Pratt comments that:

            “The reasonableness of the business valuation conclusions will usually    depend on whether the projections and variables used to estimate future   economic income benefits are acceptable to the decision maker for whom the   business valuation is being prepared, e.g. the buyer, the seller, the opponent,     the IRS, the judge.

As noted in the CCH Business Valuation Guide:

            “The amount and variety of variables that can be used in developing forecast     assumptions for both the income statement and the balance sheet are           virtually limitless, since there are unique forces at work in every company.”

Dr. Pratt further states that:

            “Getting two or more parties with different economic and business           expectations to agree on projected future benefits and the risks associated with achieving those projections is, perhaps, the most difficult task for the     business appraiser.”

On the other hand, CCH counters that the vast majority of revenue, expense, and balance sheet assumptions tend to fall into a relatively narrow universe of possibilities.  The essence of business valuation has been summarized in a number of different ways by a number of different practitioners through the years, including the following “future-related” perspectives:

            “The timing, amount and risk of the future cash flows will determine their value.”

            “The more likely the current cash flows are to be transferred to a new owner, the more they are worth.”

            “Buyers and sellers are always looking forward while attempting to find order in a chaotic world.”

            “The ability to create credible and accurate forecasts of future performance decreases as the time horizon grows.”

            “Nobody has a crystal ball!”

The act of forecasting, like most areas involving the art and science of business valuation, is very much “situation-specific” and variable from one practitioner to the next.  Despite the challenges associated with predicting future performance, it often seems that valuators create their proforma forecasts with great confidence and with a sense of precision.  The unfortunate truth is that in the great majority of cases, the accuracy of forecasted future revenues, profits and cash flows declines precipitously after one or two years into the time horizon.

The evidence of faulty forecasts can be found in many places, including the large number of unsuccessful mergers and acquisitions which was the rationale behind the Ferris/Pettit book called “Valuation: Avoiding the Winner’s Curse”.  The steady and significant default rate for SBA-guaranteed business acquisition loans is also a constant reminder of the tenuous nature of proforma forecasts.  One of the best examples of this “diminishing return” linked with future forecast reliability is found through analysis related to the so-called “Altman-Z” bankruptcy prediction tool.

The “Altman-Z” is a ratio-based coefficient which has been used by bankers and investors to successfully predict bankruptcy for publicly-traded firms (a version adapted to private firms is certainly possible, but the authors are not aware of such a tool at this time).  The connection with declining accuracy of forecasted financial performance is seen in the fact that the percent of accurately predicted bankruptcies is extremely high one year in advance and still above 80% two years in advance but less than 20% successful in predicting outcomes three or more years in advance.  In short, it would seem that the ability to assess the next full year or two of operations is relatively strong but declines rapidly thereafter.

To the extent that common time horizons for discounted cash flow analysis range between 5 and 10 years, it clearly must be considered a tremendous “leap of faith” to believe that forecasted revenues and profits three or more years into the future will be reliable, credible or even marginally accurate.  This is especially true for the smaller, privately-held firms which comprise the universe of valuation assignments for the professional business appraiser who might be reading this book.

Forecasts Versus Projections

Although the term forecast and projection are loosely interpreted to mean the same thing, there is a difference according to the American Institute of Certified Public Accountants (AICPA).  Consider the following:

Financial Forecast
Is based on ACTUAL conditions that are expected to exist during the forecast period.

Projection
Is based on EXPECTED conditions given one or more hypothetical assumptions.

Whereas a forecast presents a company’s future operations based on the actual, existing plans of company management at a given point in time, e.g. the valuation effective date, a projection normally is based on a “what if” scenario, e.g. what if the company builds a brand new manufacturing plant or what if the company doubles the advertising expenditures in the future.

In most cases, the valuator is interested in building a financial forecast, which is defined by the AICPA as:

            “Prospective financial statements that present, to the best of the reasonable      party’s knowledge and belief, an entity’s expected financial position, results         of operations and cash flows.  A financial forecast is based on the responsible       party’s assumptions reflecting conditions it expects to exist and the course of             action it expects to take.

Because the primary purpose of a business appraisal is to estimate the value of a firm as of a specific point in time and based on the actual conditions that exist at that time and that are expected to continue into the future, the proforma information utilized in DCF analysis (and its variants) is best described as a financial forecast rather than a projection.  However, to the extent that the normalization process involves certain “assumptions”, it can be argued that the proforma information is also a projection. 

For our purposes, both terms will be used interchangeably throughout the remainder of the book.

The Importance of the “Time Value of Money”

Recognizing the central importance of “future benefits” to the valuation realm, we now turn to the various perspectives, considerations and methods that are available to the professional for forecasting purposes.  Not surprisingly, there are a number of different applications that can be used to predict future revenues, expenses, profits and cash flows.  Each of these applications relate to one of several “discounted future income” valuation methods as developed over the years by practicing valuators.

The use of future income figures is most closely associated with the “discounted cash flow” family of techniques.  Utilized by both public and private firm valuators throughout the world, the DCF models revolve around the key concepts of “time value of money”, “discount rates” and “terminal values”.  As inferred earlier, modern financial theory is premised on the principle of future benefits and, by association, the time value of money.  In short, a “dollar today” is worth more than a “dollar in the future” due to the triad forces of:

  • Inflation
  • Opportunity Cost
  • Risk

Rooted in classical microeconomic theory, the time value of money represents one of the more important discoveries and applications ever made by economists.  The three factors listed above create the need to “transform” a future value back into “present value” by way of an appropriate discount factor.  Modern economies around the world have experienced routine inflationary tendencies year in and year out since the Great Depression, meaning that the same dollar “is worth less” next year than the year prior.  Having a dollar to use today also is “valuable” in that it can be invested or otherwise utilized to generate additional future dollars.  Finally, “a bird in the hand is worth two in the bush”, i.e. a dollar “in the hand” today might be worth more than “maybe two or none in the hand” next year or thereafter.

Thus it is that valuation methods which are based on future income streams require special treatment in terms of the “discounting process”, i.e. the forecasted future cash flows must be discounted back into present value in order to “compare apples with apples’.  In practice, this revolves around the derivation of the pertinent discount rate and then the application of the related “discount factor” (present value interest factor or PVIF) as located in the so-called “present value tables”.

Primary DCF Components

Whereas the mechanical and even the theoretical process of discounting is relatively straightforward, the actual application of DCF valuation techniques is filled with challenges and choices at nearly every step of the way.  Some of the more important choices include:

  • Benefit Stream
  • Time Horizon
  • Forecasting Methods
  • Discount Rate
  • Terminal Value Estimation
  • Mid-Year of End-of-Year Discounting Convention

Benefit Stream

At this juncture in our book, it is numbers one through three (and possibly number five) above which require our immediate attention.  Having elaborated extensively on the diversity of income streams (earnings or cash flows) earlier, the relevant considerations here involve not the type of benefit stream but rather the foundation for such a stream for forecasting purposes. 

It is the very nature of the valuation process to expect differing interpretations and even outright disagreement based on the same set of facts.  In many cases, the disagreements revolve around the evaluation of the subject’s probable future economic benefits.  In other cases such as in the courtroom, it is often true that historical facts carry more weight than future possibilities or probabilities.  As Dr. Pratt explains in his “Valuing a Business”, “the courts generally prefer provable historical results to unprovable expectations of future results.  To be fair, however, it is also true that “the courts” are increasingly willing to accept future-oriented analyses if the projections are well supported by fact and presented by a credible (expert) witness.

This difference in perspective dates back to at least the 1930’s based on a book called “The Valuation of Property” (James C. Bonbright, the Michie Company, reprint of 1937 edition), wherein the author insightfully describes the past, present and future relationships between earnings and value:

            “At times, the courts have come close to stating that, as a matter of principle,    the present value of a business property depends on present earnings, and          that future earnings are irrelevant because they will determine merely future        value.  More frequently they have stated that present value depends on both             present and future earnings, but with the implication that the present       earnings have the more direct bearing on the worth of the property as it    exists today.”

Cutting to the heart of modern finance theory and practice, Mr. Bonbright rightly comments that neither of the above court interpretations are correct.  Rather,

            “The truth is that, when earnings have once been “realized” so that they can      be expressed with some approach to accuracy in the company’s accounts,   they are already water under the mill and have no direct bearing on what the    property in question is now worth.  Value, under any plausible theory of capitalized earning power, is necessarily forward looking.  It is an expression             of the advantage that an owner of the property may expect to secure from the          ownership in the future.  The past earnings are therefore beside the point,             save as a possible index of future earnings.”

The NACVA’s “Business Valuations” binder addresses this dichotomy head on through a distinction between the use of “historical” or “projected” economic income for purposes of estimating the firm’s “future benefits”.  Although this distinction may be somewhat confusing at first glance (after all, forecasts are “projected” account balances in every case), the difference becomes clear via their listing of valuation purposes in terms of these two choices.  Note the following:

When is “historical” economic income used to estimate future benefits?
To estimate future benefits for tax, buy-sell and divorce valuations because the historical data is based on fact, hence considered more reliable.

Valuator should use historical economic income when…….

  • Historical economic income is indicative of expected future benefits based on the stability and trend of historical earnings.
  • Company is mature.
  • Historical operations are a good proxy for the future.
  • Future benefit stream is “linear”.

When is “projected” economic income used to estimate future benefits?
To estimate future benefits for non-tax valuations, including some litigation matters, ESOP’s and transactional valuations because the projected income may be more representative of the expected future results.

Valuator should use projected economic income when…….

  • Projections are available and are considered indicative of the expected future benefits.
  • There is a lack of reliable historical data.
  • Business is emerging (suddenly growing rapidly).
  • Enterprise is in start-up or development stage.
  • Future benefit stream is “non-linear”.

As is often the case, the choice between these two particular options is a matter of “professional and informed judgment” and based on the specific constellation of facts and circumstances at hand and available to the valuator.  Among other areas, the valuator should consider:

  • Purpose for the valuation
  • History of the company
  • Management’s expected future performance levels
  • The economic and industry conditions and forecasts at hand
  • External and internal factors that have an impact on the future benefit stream
  • Trend of historical income

 

Although “valuation is a prophecy as to the future”, it is clear to the authors that any credible and reliable forecast will be based on careful consideration of all relevant factors including the past operating history of the subject entity.  In other words, even the use of “projected economic income” (as opposed to “historical economic income”) should be based in large part on the actual results of the past.  As another famous saying goes, “Past is prologue” (at least some of the time, or according to Hitchner “In some circumstances, the past is not indicative of the future.”).  Finally, the landmark valuation case of “Central Trust v. United States” includes a finding by the court that “past earnings are important only insofar as they reasonably forecast the future earnings”.

Time Horizon

Irrespective of the selected benefit stream and the choice between “historical” versus “projected” economic income, it is necessary to establish a “time horizon” over which the estimated future benefits will be provided by the valuator.  Several perspectives exist in regards to this decision, including the following:

  • Business cycle of the company. (NACVA)
  • If the company has been showing losses, the projections should go out far enough to allow the company to return to a level of normal sustainable profitability (and vice-versa)…..the willing buyer is going to be looking for the income stream that he or she can count on beyond the near term. (Trugman)
  • Five years. (IRS R.R. 59-60 and 68-609)
  • Five to seven years to adequately cover the effects of external and internal factors that would be expected to continue in the future. (NACVA)
  • Since it is difficult to reliably predict beyond five or seven years, many valuators only forecast year by year for that period and then, for the final year, a simplifying assumption is made that the final year’s earnings (or cash flow) will continue to grow in the future at some assumed constant long term sustainable annual rate of growth. (CCH)
  • Most professional analysts are reluctant to forecast beyond five years, in large measure because of the high probability of error in such long term forecasts. (Ferris/Pettit)
  • The “Formal Projection Method” uses projections for a specified number of future years (generally five) referred to as the “explicit”, “discrete” or “forecast” period, whereby its length is determined by identifying the year when all the following years will change at a constant rate…..With exceptions, three to five years is the standard length of the explicit period. (Hitchner)
  • HOLT Value Associates, Inc., prepares forecasts of up to forty years for potential acquisitions.  The company has achieved considerable success using a mean-reversion model for its forecast periods beyond ten years. (Ferris/Pettit)
  • Projections should go out far enough into the future that they represent sustainable future levels of income for the company. (Trugman)

Forecasting Methods

Common sense dictates that the utility of forecasted financial results is a direct function of their credibility, reliability and accuracy (both real and perceived).  Given the common attribute of every business valuation involving some type of “conflict” or diametrically opposed interests on the part of the interested parties, the goal of the professional valuator is normally to prepare an estimate of business value which is convincing in nature and generally believable by the opposing side.  The credibility of the appraiser and the quality of his or her work are never more important than when “doing battle” on the field of “discounted future benefits.”

The number of approaches taken by appraisers when forecasting future performance seems to be as large as the number of appraisers who apply them.  Each professional seems to have developed their own semi-unique approach for estimating future economic performance, drawing in part from authoritative sources and in part from their own personalized “crystal ball”.

From a “best practices” perspective, a number of forecasting techniques are utilized by today’s professionals.  Before presenting formal forecasting methods, a review of general factors and considerations related to the preparation of forecasts is in order.

Key Factors and Considerations in Preparing a Forecast

Once the benefit stream has been selected (based on the selected valuation method) and the discounting timeframe established, the valuator can begin to contemplate the key factors and considerations related to the preparation of a formal proforma financial forecast for valuation purposes.  Similar to other important areas of private firm valuation, the approaches and perspectives presented by the spectrum of authoritative sources are both diverse and consistent at the same time.

The practical, “how to” approach that permeates the PPC Guide to Business Valuation is a sound starting point for our review of best practices.  In addition to the coverage inside the PPC Guide, they also offer “PPC’s Guide to Forecasts and Projections” (addresses the complex rules that apply to presenting forecast information and can be ordered by calling PPC at 800-323-8724). 

Perhaps the first consideration involving the preparation of forecasts for valuation purposes concerns the availability of detailed and credible projections created by the subject firm’s management or its independent CPA.  Whereas the PPC Guide strongly encourages the use of company forecasts wherever feasible, other expert sources disagree with this recommendation.  To the extent that any forecast utilized to value a subject firm is the ultimate and sole responsibility of the valuator, over-reliance on company management is at least a risky proposition.  The consensus seems to be a middle-of-the-road selection, calling for careful usage of management forecasts (or insights) but final reliance on the valuator’s detailed analysis of the company, industry and economy.

It should be noted that if company management prepares forecasts and they are utilized by the appraiser, then additional adjustments may be necessary to “normalize” the projected figures.  On the other hand, if the appraiser prepares the forecast independently of a management forecast, such adjustments will be made in conjunction with the appraiser forecast. 

Use of Management Forecasts

Here are a few relevant perspectives regarding the use of management forecasts/insights for valuation purposes:

  • Whether the company prepares the projections or whether the analyst prepares the projections with the assistance of management, the analyst needs to evaluate the projections for reasonableness and to determine that the projections properly reflect expected future operations, the economic and industry forecast and the external and internal factors that are expected to affect the future benefit stream. (NACVA)
  • If (management) projections are to be used, the appraiser should attempt to compare previous projections against actual results (even budget versus actual).  This will give the appraiser a comfort level regarding management’s ability to project the future of the business. (Trugman)
  • The valuation analyst uses normalized historical data, management insights and trend analysis to analyze formal projections for the explicit period….Management insights will be very helpful in deciding whether current cash flows are likely to be replicated in the ensuing years.  If…next year will be similar to last year, then current earnings and cash flow may be used as the basis to value the company. (Hitchner)
  • Conduct a thorough initial company interview….the appropriate probing questions should be asked …..to develop an understanding of the forces that shape the company: the revenues it realizes, the product demand, the impact of competition and its outlook. (CCH)
  • Avoid accepting management’s forecast without doing a reasonableness check. (Trugman)
  • The consultant should always attempt to have the forecast results and assumptions approved by the management of the company being valued.

If management willingly and aggressively (hopefully) provides the appraiser with a forecast and the appraiser is not comfortable with their content, several options exist to help remedy this “uncomfortable” situation.  Per Trugman, these options include:

  • Discuss with management any items that might need to be changed.
  • Adjust the discount rate for the additional element of risk by increasing the rate used.
  • Do not use the multi-period benefit stream discounting method in favor of the single-period income capitalization method or other valuation approaches suitable to the circumstances of the particular assignment.
  • Withdraw from the engagement…..there are times when the projections are so critical in the valuation process that it becomes impossible to procced with the job.  An example would be when the valuation is being performed for the purpose of obtaining financing.
  • If the projected operations are expected to be stable, do not use a multi-period model if a single-period model will suffice.  A single-period model is easier to understand and there are fewer variables to be attacked, especially if the valuation might be used in a litigation (environment).

General Forecast Considerations

After the proper role has been established regarding the use (or lack thereof) of management forecasts and/or insights, the heart of the matter can then be addressed.  The prediction of actual revenues, expenses, profits, cash flows, assets and liabilities in future periods is the “real work” to be completed by the valuator, i.e. it is the most time-consuming and ultimately most important aspect of forecasting.

The PPC Guide suggests that the following “forecast considerations” are among the more important general perspectives related to the forecasting process:

  • The financial forecast should be based on assumptions about normalized future operations, and should be presented in accordance with GAAP.
  • The key factors or assumptions that serve as the foundation for the forecast should be identified.
  • The key factors and assumptions should be reasonable.
  • The forecast period should extend through the terminal year after a stabilized level of operations is obtained.
  • The consultant (valuator) should always attempt to have the forecast results and assumptions approved by the management of the company being valued.
  • CPA consultants have additional presentation and reporting responsibilities.
  • The consultant should consider obtaining other resource books about forecasting, e.g. PPC Guide to Forecasts and Projections.

 

As noted earlier, management forecasts are likely to be prepared in accordance with GAAP (or something very close), using the familiar income statements and balance sheets as their foundation.  The more sophisticated management is, the more likely that such forecasts will involve assessments of “cash flows” and “required investments” in working capital and fixed assets. 

Returning to the “accounting” versus “economic” distinction presented in the section on normalization, it can be said that the accounting statements can be forecasted for purposes of traditional financial statement analysis pertaining to future periods and the economic statements can be used for purposes of “valuation” applications within the Income Approach (discounted future earnings).

All Forecasts Begin with Earnings

It is theoretically possible to forecast and then discount any one of the nearly twenty different measures of income (earnings and cash flows) presented earlier.  For that matter, it is possible to forecast and discount any measure of income that is conceivable by the valuator.  For example, commercial banks have been known to create their own internal-use-only standardized measures of income which are truly unique.  The SBA policy and procedures manual and public notices from the past have included their own brand of “future earnings” that incorporates the buyer/borrower/new owner’s anticipated living expenses (deduction from earnings) into their forecasted income.

Whether earnings or cash flow or something totally unique, the family of valuation methods within the “discounted future” realm all involve forecasts and discounting into present values.  Although the term “discounted cash flow” is more proper from a financial theory perspective, various authors utilize terms such as “discounted future earnings” or “discounted future income” to describe what is ultimately the same process.

As noted in several places throughout this book, all measures of cash flow include a measure of earnings (whether pretax or after-tax), thereby requiring the forecast of future earnings as a starting point for all discounted future-oriented valuation methods.   Although it is possible to discount a pretax earnings or cash flow benefit stream, the great majority of multiple-period discounting models revolve around after-tax measures.  Both traditional DCF analysis and the SBA’s transaction-driven discounted future earnings methods are based on after-tax cash flows and begin with after-tax income as their starting point.

Discounted Cash Flow Analysis and Net Cash Flows

Given the predominance of “net cash flow” as the income measure of choice among professional valuators, the following analysis shall assume the use of “net cash flow to equity” for purposes of exposition.  In addition, traditional DCF analysis shall serve as the relevant valuation method in conjunction with the related forecasting analysis.

As one peruses the universe of authoritative sources, the great majority of authors utilize “net income” or “after-tax income” as their starting figure for net cash flows (to equity or invested capital).  As highlighted earlier, Trugman utilizes “normalized net income” as the starting point to highlight the importance of the normalization process and all of its many facets.  The PPC Guide also stresses the normalization effort within its coverage of forecasting methods as seen in the first item on the list presented earlier (General Forecast Considerations). 

Despite the frequent perspective found throughout the valuation literature that GAAP-based financial statements are not conducive to the valuation of private firms, the PPC Guide actually stresses the importance of assessing a company’s historical financial results by viewing those results under normal conditions and in accordance with GAAP.  To the extent that balance sheet adjustments within the normalization process such as restating assets from book value to fair market value are made specifically to correct for GAAP (historical cost) perspectives, this argument is confusing at least on the surface.  This argument makes more sense in terms of the adjustments made for comparability purposes, e.g. restating the financials on the basis of industry-wide accounting practices (both the income statement and balance sheet).

In essence, the same key principles of normalization as defined and discussed in chapter XX also apply to forecasted operations, i.e. they should be based on reasonable assumptions which “capture”           the underlying “economic reality” of the subject enterprise.  This includes all of the adjustments described within the five categories presented earlier, i.e. adjusting for excessive owner compensation (disguised profit), impact of nonoperating assets, non-recurring events, etc.  Thus it is that the first element of net cash flow is optimally described as “normalized” net income rather than simply net income.

Normalized Net Income and Tax Implications

One of the more challenging and potentially confusing aspects of normalization involves the interpretation of income tax-related adjustments.  Such adjustments take many different forms, including:

  • Common normalization adjustments which change pretax income
  • Forecasting future tax rates
  • Tax affecting S-corporation earnings

Whether normalizing a single period of income or multiple future periods, the normalization process will often alter the subject’s operating income, pretax income and therefore after-tax or net income.  The typical adjustments and their tax impact can be quite confusing or appear to be inconsistent in certain situations.  For example, the PPC Guide recommends restating cash basis financials into an accrual basis format while at the same time certain variants of net cash flow require adjusting back to a cash basis (to calculate cash basis tax liabilities).  Understanding this sequence requires distinguishing between the typical normalization process and secondarily the calculation of a specific variation of net cash flows (reverse normalization?).

Because the forecasted normalization adjustments will alter forecasted pretax income, the forecasted tax rate will also require adjustment.  Depending on the relevant standard of value (fair market value versus investment value or strategic value), the entity type of the seller and the typical buyer (C-corporation, S-corporation or Sole Proprietorship), the forecasted tax rates will vary.  Either corporate income tax rates (state and federal) or personal income tax rates (state and federal) will be used against forecasted taxable income in accordance with the pertinent facts (as below):

Standard of Value Type of Entity Relevant Tax Schedule
Fair Market Value C-Corporation Corporate
  S-Corporation** Corporate or Personal*
  Sole Proprietorship Personal
     
Standard of Value Type of Entity Relevant Tax Schedule
Investment Value C-Corporation Corporate
  S-Corporation** Corporate or Personal*
  Sole Proprietorship Personal

*This choice is a matter of debate and involves the contentious issue of “tax affecting” S-corporation earnings, i.e. imputing an entity level tax despite the tax-free operation of such enterprises (profits “pass through” to the shareholders)

**S-corporations are one of several types of “pass-through” entities that also include limited liability companies and partnerships.

In most cases, the tax rate applied should be that which is applicable to the subject entity as a stand-alone company, i.e. apply corporate tax rates to a C-corporation.  On the other hand, if the valuation is being completed for a specific and known buyer, it may be appropriate to use the purchaser’s probable tax rates (investment value perspective rather than fair market value).

As the above chart suggests, the selection of tax rates is complicated by the presence of the various “pass through” entities such as S-corporations and LLC’s.  These entities are also described as “nontaxable” because the profits “pass through” to the individual owners (shareholders, members and partners).  They do not pay federal taxes or, in most cases, state taxes on income.  The prevalence of net cash flow to equity and the Ibbotson build-up discount rates within the income approach creates a problem for pass-through entity valuation in that the appropriate perspective for both the income measure and the discount rate is “after-tax” (net cash flows are after-tax and the Ibbotson rate is “built” upon long term after-tax returns).

Accordingly, most professionals believe that it is improper (inconsistent) to use after-tax market data to value pass-through entities unless the necessary adjustments are implemented.  Several options exist to remedy this inconsistency, including but not limited to the following:

  1. “Tax affect” the earnings using corporate income tax rates
  2. “Tax affect” the earnings using a known purchaser’s income tax rates
  3. “Tax affect” the earnings using corporate income tax rates and then increase the value to reflect the firm’s nontaxable status
  4. Estimate the discount rate using nontaxable “public entities”

The first two options above appear to be the most widely-utilized tactics for valuing pass-through entities, despite constant opposition by the IRS and even the tax courts (see chapter XX for more coverage on “tax affecting”).  One additional option is worthy of discussion here and is found in the PPC Valuation Guide.  This technique involves increasing the cap rate determined by either the build-up or adjusted CAPM methods to reflect the additional risk associated with pass-through entities as compared to C-corporations.  The adjusted, higher cap rate can then be applied to the company’s pretax earnings to arrive at an estimate of the company’s value.  The PPC Guide cites the following factors in justifying the higher risk assessment for pass through companies:

  1. Sole proprietors and general partners typically have unlimited liability
  2. S-corporations are subject to several restrictions, including:
    1. Maximum 75 shareholders
    2. C-corporations cannot be shareholders in S-corporations
    3. Deductability of pass through losses and deductions to an S shareholder are restricted by insufficient tax basis (in stock and debt), lack of material participation by shareholder (subjects loss to passive activity rules), application of the “at risk” rules, lack of tax attributes available to most C-corporations (corporate dividend deduction, use of existing C-corporation investment tax credit, net operating loss or capital loss carryovers)


Applied Forecasting Considerations and Techniques

Having laid out a theoretical foundation for forecasting, we can now turn to the actual “nuts and bolts” of effective forecasting.  Once the valuator has selected a valuation method which requires forecasting, e.g. discounted cash flow analysis, the relevant measure of earnings or cash flow must be determined.  As stressed elsewhere, DCF analysis will typically revolve around “net cash flows” (whether to “equity” or “invested capital”).  Although there are obvious differences between the equity versus invested capital cash flows (involving long term debt and interest expense), much of the forecasting requirements are the same.

As Trugman notes, “one of the most important parts of the valuation process is the projection of the future benefits stream that will be used in the income approach.”  As such, the typical starting point is the historical income statement, which must be analyzed and adjusted to reflect the economic income of the business being appraised.  Recall from chapter 11 that the more common adjustments include:

  1. Adjust inventory accounting method to conform to industry practice or expected future treatment, e.g. from LIFO to FIFO.
  2. Adjust depreciation to reflect current economic write-offs more accurately, e.g. based on the results of professional equipment/machinery appraisers.
  3. Remove non-recurring items and non-operating income and expense items.
  4. Adjust for “related party” or non-arm’s length transactions

Although easier said than done, it is clear that a quality forecast requires a full and accurate understanding of the subject business, its industry and current/expected economic conditions.  As such, all of the questions asked during the qualitative and quantitative (see chapter XX) review and analysis performed earlier in the valuation should be reviewed and expanded upon for purposes of projecting future performance.  Some key questions to ponder or re-visit include the following (Trugman):

  1. Are sales concentrated in a few customers (risky) or are they spread out among many customers?
  2. Is the business trendy?  Is its popularity only temporary, or is the business expected to be around for a while?
  3. To what extent is the business able to control its own destiny?  Is it dependent on another industry?  For example, the retail furniture industry has about a six month lag behind the residential housing market.  If new home sales go down, retail furniture will follow soon thereafter.
  4. Is the business subject to seasonal or cyclical fluctuations?  If so, where in the cycle is the business?
  5. Does the company have a problem with its suppliers or source of supply?  What if the company imports a product from a particular country and the government imposes a trade restriction?
  6. Is the business dependent on technology, and if so, is the company keeping up with the industry?

The primary challenge is to transform your knowledge and insights into the subject firm, industry and economy into actual, discrete forecasted numbers which reflect the underlying forces and trends over the next several years.  The various authoritative sources reviewed in this book each present their own unique version of forecasting techniques.  The PPC Guide breaks down the forecasting “factors and assumptions” into the following general categories or “building blocks”:

  1. Revenues and expenses
  2. Cost of sales and inventory
  3. Other costs
  4. Property and equipment and related depreciation
  5. Debt and equity
  6. Income taxes

As noted earlier, a choice must be made as to whether the historical or projected financial statements should be used to forecast future performance.  Whereas historical data is based on facts, they may be considered more reliable.  On the other hand, projected figures may be more representative of the expected future income potential of the subject firm.  The use of historical data for forecasting purposes is the focus of the NACVA’s Business Valuation book, wherein several methods are presented to “mathematically” forecast future benefits.

The NACVA approach distinguishes between “linear” and “non-linear” benefit streams in its coverage of forecasting future income.  Once the analyst has adjusted the historical income statements to a normalized basis and defined the type of earnings which will be used, an estimate of expected future benefits must be made.  A linear benefit stream is simply one which is expected to remain constant or grow/decline at a constant rate.  There are three primary methods used to estimate a linear benefit stream based on historical economic income:

  1. Unweighted Average Method
  2. Weighted Average Method
  3. Trend Line – Static Method


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