One of the benefits of attending a live conference is the chance to network with all sorts of practitioners. You can sometimes glean as much valuable information during a lunch break or an evening reception as you can during the formal conference sessions. During the recent ASA Advanced Business Valuation Conference in Houston, we randomly asked attendees about a topic that has triggered much attention recently: prospective financial information (PFI). We asked about their experiences in spotting warning signs that management prepared forecasts and projections may be unreliable. The following list is certainly not exhaustive, but it gives you a few of the things to look for that came to the minds of the experts we asked.
- Ulterior motives. That is, the forecast was prepared with an eye toward the valuation outcome (e.g., optimistic forecasts for bank financing; pessimistic forecasts for a business caught up in a divorce).
- Past forecasts have been inaccurate—they don’t compare with historical results. If they’re always off the mark, why are these new ones reliable? Maybe the preparer just doesn’t have the skill to do this.
- Forecasts are prepared with no input from business unit heads.
- Growth rates and margins are inconsistent with analyst expectations for public firms in the same market. What assumptions are behind these inconsistencies?
- Forecasts produce a value that is way out of whack from values through other methods. Unreliable forecasts can be the major reconciling item between methods.
- No assumptions back up the projections, especially when the future is expected to be different from the past.
- Only income statement forecasts are provided. This shows a lack of concern about capital expenditures or financing needs. Maybe the forecasted growth is outstripping the company’s capacity to finance that growth.
- The forecast does not cover an entire business cycle. How did the business do during peaks and troughs?
- The forecast is predicated on some unusual assumption. Be extremely skeptical and examine this assumption very carefully. Maybe the assumption relies on the ability to obtain financing or make an acquisition.
- An excessive amount of the overall value lies in the terminal value. Carefully examine the inputs to the terminal value.
Finally, we asked what should be done if you can’t obtain a reliable forecast or are unable to create your own that can be agreed on by management. Advice: Reject the income approach or walk away from the engagement.