Well over half (59%) of CFOs say that an overstated revenue forecast is the No. 1 valuation risk when assessing a prospective acquisition, reveals a survey from Deloitte. This is by far their greatest concern in terms of valuation, with understated expenses a distant second (14%). Other worries are: an overstated exit multiple or terminal value (12%), understated capital needs (6%), understated discount rate (2%), and “other” (6%).
Big picture: Overall, an inaccurate target valuation is the third biggest concern of CFOs about M&As, with 14% citing this issue. Failure to effectively integrate the target is the top concern (43%), and a changing regulatory and legislative environment is in the No. 2 spot (16%).
“Target companies may be expected to view their cash flow projections optimistically, believing that recovery will likely drive market opportunities and growth,” explains Eric Pillmore, senior advisor to Deloitte LLP’s Center for Corporate Governance. “Yet how quickly, and how successfully, the post-transaction company may be able to exploit growth opportunities has become an open question under current circumstances,” he adds. Past disappointments and the write-downs taken during the financial crisis of 2007-2008 coupled with the weakness of the current U.S. economy may help explain why there is a “strong reinforcement for a cautionary view to M&A,” he says.
What to do: Of course, valuation analysts must regularly be on guard about the reliability of management projections. One good idea is to check the forecast against what industry analysts are projecting. If there is a big difference, can management explain it? Also, check how well management did with past forecasts. Did it hit its targets or was it way off? Also, management should have had all of the business units and department heads involved in coming up with the projections.
If you can’t trust the projection management gives you, try to adjust it or develop one on your own. If that’s not doable, you can choose to reject the income approach altogether.
If you do end up using management projections, include some disclaimer language in your report. The gist of the language should make it clear that you cannot guarantee that the forecasted results will be achieved, and therefore your conclusion of value could be materially affected.
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