"It's harder now to avoid double counting risk when conducting valuations," Marc Bello tells a large NACVA group in the Dallas Ballroom at the Omni in downtown Dallas. "What do we have to do to avoid counting risk both in our analyses of future cash flows and also in our cost of capital calculations?"
Marc starts with some thoughts on how he examines future benefit streams now that we're in an environment where some appraisers are adjusting factors like the equity risk premium. One correlation Bello considers--often with a graph to emphasize the patterns--is the comparison of free cash flow to equity vs net income. "Using an income approach, we're going to have to make judgments about where the business is headed," he says, so looking at the historical trends can reduce the risk of your assumptions, at least.
Marc suggests some techniques to help:
- "If you see volatility such that you're not certain about where net income is going, perhaps you need more than 3 or 5 years of history," he suggests.
- Similarly, if the company is coming off a bad net income year, weighting most recent years more heavily (for instance using a 5-4-3-2-1 weighting) needs to be reviewed very carefully, and compared to 20-20-20-20-20 models for sanity.
- And, if the company is either high or low compared to historical norms for net income, look to the cash-flow carefully: "if the company had lower net income in 2011, and entered 2012 with low working capital," Marc asks, "how likely is it that management will be able to take advantage of an improving economy to increase net income? You need to ask how cash flow can increase $1 million in one year, and where that growth comes from. If it does occur, what are the current working capital implications?"
Industry research from BizMiner, or First Research, or KeyValueData, or IBISWorld become even more important, Bello believes--and he'll graph industry benchmarks with the economy, the free cash-flow ratios. "Do these indicators show my company is more or less volatile than the world around it? If you review that graph, it will give you more confidence in your ability to create a DCF for the first time for your client."
"Since you can't throw in a company specific risk factor of 15% without being laughed at, the most critical thing is the forward-looking analysis of the benefit stream," says Bello. "We don't have that much flexibility with cost of capital since most of the numbers are now tied to solid statistical databases." So, Bello believes appraisers need to fully apply their finance, accounting, and other skills to the cash-flow projections.
And that begins with:
- Are sales so low to be too risky to forecast?
- Consistant positive EBITDA for previous five years
- whether working capital is sufficient to meet future growth (or "perhaps the owners have been supporting a too-rich lifestyle, and there's now nothing left")
- evaluate distributions to net income
- is the current capital structure optimal (which is why the projected balance sheet is so important to DCF analyses)
And what about the denominator, cost of capital? We have a good idea of what to expect, but Bello points out that from the owner, the lender, or the acquirer--the idea of cost of capital looks different. Meanwhile, we've entered a period of "chaos in the use of the build-up model, where you start hearing about adjustments to the ERP or 'normalization' of the risk free rate." It's a perfect storm between the risk free rate, and the additional premium required for the risk of the subject company.