Are you neglecting your cash flow forecasts?

Inputs for the cost of capital are increasingly evolving, and much debate takes place over which sources reign supreme—just look at the loyal camps that support ERP data from Duff & Phelps and those that support Ibbotson’s. With all this debate and focus on the cost of capital, are we neglecting our earnings forecasts? Linda Trugman thinks so. In her 6/4/2010 presentation at the NACVA conference in Miami, Trugman posited that “People have become so focused on the denominator—the cost of capital—they forget the importance of the numerator.” We all know how a few percentage points in the cost of capital can affect your value conclusion, but your cash flow predictions are equally important. When using a capitalization rate to forecast cash flows into perpetuity, she urged attendees to stop and think: “Does this make sense?”

With the cost of capital taking center stage, she has seen some appraisers put little time and effort into forecasting cash flows, such as inappropriately using a five-year average when it’s not a proper indicator of the future. Was the company making large capital outlays in the last few years, but unlikely to be making expenditures of this size in the future?  Was the company making sizable payments towards debt in the last few years that are unlikely to continue (the debt will be paid off and they are unlikely to require more debt capital)? “Think outside the box people,” urged Trugman. Failure to consider what is probable in the business’s future could significantly undervalue it. “We get so wrapped up in our models and spreadsheets that we forget the basics.” Food for thought.