Business Valuations – Appraiser vs. Management Forecasts
When attempting to establish a company’s valuation, it is necessary to look at historical financial information whilst at the same time trying to forecast the business’s future financial performance. Forecasting requires you to form assumptions about the future, and these assumptions will vary depending on who produces them. Unless you are a skilled valuation expert, you will often hire a business appraiser (sell-side advisor, IB analyst, or valuation expert) for this work. A company’s management will also have their own forecasts. If you are a potential buyer, you need to balance the views of the independent appraiser and business management. It is worth noting that if you are management, looking at an independent appraisers’ valuation is also a good practice.
The crystal ball
As discussed multiple times in our blogs, business valuation is an art, not a science. But that does not mean it is simple or that there are not best practices. If you are looking into the future, you need to look at business returns and arguably more importantly, if you are a buyer, business risks. Ultimately, a company will be valued more than its current assets and earnings. Therefore, you need to assess how likely you think it is that a company will reach this apparent forecasted value. The other major problem with future forecasts is that there is always a bias. Owners are passionate people, it is why they started the company. However, this can mean that their future view might be through rose tinted glasses. We recommend looking at an independent valuation prepared by a business appraiser. The caveat here is that business appraisers are also often wrong, and notoriously conservative. Management generally knows the industry inside and out, whereas an appraiser is employed to bring an objective view to the table.
An independent look
A business appraiser will look at a company through impartial eyes. This is good and bad. It is good because the forecasts will be subjected to thoughtful scrutiny, objectivity and independence. What they lack is years of experience, and analysts have a reputation for missing trends. This is why they are not entrepreneurs themselves. View their outcomes as likely, but conservative. From the appraiser’s perspective, under-forecasting is never seen as bad as over-ambitious forecasts. It is important to have a conservative view, but you need to keep in mind that their appraisal could also be scaring you off the next best thing. Unless you are a large organization, you will normally only have one chance at picking a business appraiser, so you should devote time into their selection. The best thing to do here is to ask for a portfolio of deals and conduct some due diligence of your own.
Rosy management forecasts
Yes, management forecasts are often rosy and based on aggressive goals. This isn’t entirely a bad thing. It means the owners are passionate and excited. However, passionate management teams tend to either underestimate the potential pitfalls or miss them all together. Sometimes what seems so obvious after the fact is a bit grey beforehand. Management teams often look at pitfalls as opportunities, and therefore often fail to include what-if analysis in their assumptions. Keep in mind, even for listed stocks, market analysts normally have opposite calls (Buy or Sell) and drastically different forecasts. More so, companies are often looking to sell following massive business headwinds, and simply assume that these trends will continue in the long-run. This could be true, but basic economics disagrees.
DCF issues
The most common way to value a company is the discounted cash flow (“DCF”) analysis. Although previous earnings help forecast future figures, a company’s complete financial history is not included with a DCF valuation. This makes future earnings the most important variable, and why finding the balance between management and appraiser forecasts is so important. You are looking to buy or sell a future asset. Unless the company is a large, fast-growing tech company (we will be writing a blog on this shortly), DCF will form the foundation of a company’s valuation. This is impacted by two major things: future earnings and a discount rate. If we ignore the discount factor, for now, the future cash flows are very important. For this reason, you must include a balance between bullish and bearish outcomes.
Ask the uncomfortable questions
If you have asked an appraiser to value a company, including your own, you need to challenge both the appraiser and management’s outputs. If valuations from management are unexpectedly high when compared to an appraiser, find out what is driving the difference. Is it market, company or both? Even if you are management, you need to find out what your team has decided and why. In the end, the management team might be closer to future performance than the appraiser. Don’t rule out management because you assume they will be bullish. It is just as likely that the appraiser has missed something than found something you overlooked, so dig down to the details. If you are looking to buy a company that is not yours, you will need to follow this subtle, but objective question session with both management and the appraiser.
The objectivity advantage
Normally an appraiser will build out their earnings forecasts from scratch. This is called a bottom-up valuation and is often a good process to go through for a company regardless of other factors. The appraiser will form a set of assumptions based on their research. Their research will generally be a combination of talking to management and other industry experts. Alternatively, management often uses old models, normally provided to them from a previous appraiser, which they simply continue to roll forward and adjust. These models are often lacking objectivity and new assumptions. An appraiser is not required to arrive at a high valuation. They are expected to provide a realistic measurement of what the business is worth. This objectivity often comes at a price and they may fail to cover all angles. They will have an opinion based on a very limited knowledge of the industry and more importantly on the company they are valuing. But this is very important to include in your analysis.
Bottom line
No clear answer exists when choosing to listen to management or a business appraiser. An outsider may lack the understanding of the value drivers that can support the earnings growth the company’s management expects. Management are the experts but are often bullish and view things through rosy glasses. We suggested to look at both outputs and find a consensus you are happy with.
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