The three main factors affecting a business valuation are: (1) cash flows; (2) discounts – for the lack of control and/or marketability; and (3) discount rates.
Perhaps due to our Singapore ‘kiasu’ mentality, there is a greater focus on discounts – attorneys would often spend more time scrutinising and validating discount rates and the justifications for lack of control and marketability; while the analysts use the business owners’ cash flow projections at face value in calculations for business valuations.
The ignore on cash flow projections is surprising because they have as many assumptions and nuances that require a good amount of focus and due diligence.
The Main Consequences of Insufficient Time Spent On Cross-Examining Cash Flow Projections:
1. The choice of discount rate does not match the level of risks in the cash flow projection
Valuation analysts should be able to match the level of risk of a business with its cash flow projection, which requires a sound knowledge of the assumptions and inputs used in working out the projections, and use it to assess the degree of risks in the projections.
For example, a business owner may use some biases in the calculations – inadvertently or on purpose. In such cases, the valuation analyst can adjust the discount rate to cancel any unfair effect of these biases.
2. Inconsistent cash flow assumptions from short-term to long-term
Assumptions for long-term cash flow projections should be derived from the context of assumptions for the short-term projections.
This is logical because a valuation analyst needs to first understand the business’s plans for near-term growth projection in order to select a viable long-term growth rate.
The same logic would apply to selecting the point of terminating period since the period of cash flow projections may fall outside the period of business stability and growth. Hence it is worthy to assess the sustainability of a business operation: when will long-term stability be achieved – by Year 5, 7 or 10?
3. Inconsistent standard of value may be used in assumptions for cash flow projections
For such cases, the projections would need a round of normalizing adjustments.
Some possible areas to look into would include:
- The rent or staff compensation are not stated at market rates;
- Personal or discretionary expenses are included in the projected expense items.
Other areas can be identified from interviews with the management, the financial reports and analysis, and the margin and trend analysis.
Based on the above, it is clear that valuation analysts should pressure test all financial information of a business, and eliminate any baseless or non-viable assumptions. Attorneys should also spend adequate time to effectively cross-examine the analyst’s cash flow projections and assumptions.
Suggested Checklist Of Considerations For An Effective Cross-Examination Of Cash Flow Projections:
- Are the revenue growth rates reasonable? (Here, a comparison between the projections and the economic and industry expectations can be made.)
- Do the capital expenditure and working capital forecasts align with the industry trends? If not, are there explanations – and are they relevant, updated and logical?
- Are there ways to verify the business’s capacity to attain the projected level of operations? If the business does not have the capacity, does the business owner / management have viable solutions, such as considering the necessary capital expenditure needed for the growth forecast assumed in the projections?
- Are there past records or historical evidence of long-term projections from the business owner / management?
- Is there substantial evidence to prove that the projections were derived during the business operations under normal circumstances?
- Are there ways to verify that the calculations for the projections are mathematically sound?
- Is there a difference between the current projections and the actual historical performance trends? Are the explanations for the difference or any discrepancies logical or tally with the business financial reports?
- What is the track record of the business owner / management in making projections? (This can be done via comparing their past projections to the actual historical results.)
It is worthy to note that the checklist above is not exhaustive; there may be more considerations to follow up. Some considerations may even be more important than others depending on the circumstances and facts involved.
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