Valuation experts frequently receive forecasts that start modestly but accelerate dramatically in future years. Many academic studies conclude that overly optimistic forecasts are the norm—and few SMEs ever meet their targets. It’s generally up to business analysts to adjust forecasts as part of their business valuation work.

But what if the valuation expert has confidence in what may appear to be unrealistic projections from management? How can the expert provide evidence in support of those future claims?

In a blog post, Chris Mercer (Mercer Capital) recalls having a hockey-stick projection from a bank that currently had low earnings. It appeared that the bank could not possibly achieve that level of performance found in the bank’s own current capital plan for the next five years, which had been prepared for regulatory review in the normal course of business. Mercer was accused of unrealistically relying on the bank’s capital plan.

In response, Mercer referred the attorney to an exhibit in the valuation report that compared the previous five years’ performance with the earnings and returns of the capital plan. “There, it was clear that the projected returns (on assets and equity) were within the levels achieved by the bank in the previous few years, and below the current level of the bank’s peer group,” Mercer writes. “Value today is a function of expectations for future performance—and the expectations used were in line with past performance, management’s stated plans, management’s business plan, and the performance of similar banks.”

This situation illustrates the importance of professional skepticism, especially when reviewing management’s prospective financial information (PFI). Common procedures include, but are not limited to, a comparison of prior forecasts to actual results, comparison of PFI to industry expectations, checking the PFI against other internally prepared financial information for consistency, a comparison of entity PFI to historical trends, an understanding of who prepared the PFI and how often it is prepared, and math and logic checks.