Business valuations are often based on estimates of expected cash flow made by the company’s management. Even when estimates are prepared by a valuator or the company’s CPA, it’s often based on management’s representations about the company’s future plans about potential threats and market opportunities. So, it’s important to evaluate whether expected cash flow seems reasonable, or whether the estimate is overly optimistic or pessimistic.
Fundamental building block
Let’s take the following example of a valuator who has two recent estimates of net cash flow to choose from:
- Equity net cash flow of $5 million based on a projection the company’s owner prepared to apply for financing the construction of a new plant, or
- Equity net cash flow of $4 million based on a forecast prepared by the company’s CPA in accordance with the AICPA attestation standards.
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, every $1 of additional net cash flow results in an extra $5 of value at a 20% cap rate if the valuator uses the projection rather than the forecast.
Projection vs. forecast
How do you determine which of these two hypothetical estimates is appropriate? When evaluating cash flow estimates, it’s important to understand the difference between the terms “projection” and “forecast.”
Projects are defined by the AICPA 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.
Forecasts are defined 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.
Generally, valuators use forecasts, that is, expected results based on the expected course of action when appraising private business investments. Projections are sometimes used, however, when determining fair value in a shareholder dispute, when calculating economic damages, or evaluating capital budgeting decisions. The date of and reason for preparing the estimate also can impact its relevance.
Know the type of estimate
Although it is fine and acceptable for valuators to rely on an estimate of expected cash flow that’s prepared by the company’s management, it’s important to understand the type of estimate that was created. Even small differences in expected cash flow can have a big impact on the value of a business.