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Some further thoughts on ‘most likely outcome’ forecasts for business valuation
Every financial analyst is struggling with forecasting methodologies now. And, while auditors still need ‘the number’ from their business valuation expert, others are questioning that complete dependence on ‘most likely outcome’ valuation conclusions. The limitations of such single-point estimates suggest that valuers consider scenario analyses and probability-weighted expected values to their analyses.
A number of UK insolvency and commercial cases have recently hinged on the reliability of management forecasts post-Brexit and post-COVID-19. Now, a US case this month also emphasises the risks of faulty forecasts, particularly if management’s previous forecasts have missed the mark. Earlier this year, a New York trial court presiding over a buyout dispute featuring an online wholesaler of faucets, sinks, and fixtures rebuffed the departing shareholder’s valuation. His expert’s discounted cash flow analysis collapsed on account of unreasonable projections that the company had used to secure a loan from a bank.
A digest of Magarik v Kraus, Index No:606128-15, Nassau County, Supreme Court of New York, J. Destefano (April 10, 2020), as well as the court’s opinion and the parties’ post-trial briefs (providing further valuation details) will be available soon at BVLaw.
Some of the challenges and biases ascribed to current use of forecasts include:
- Forecasts are based on the premise of success. A new analysis by The Footnotes Analyst confirms the experience many BVWire—UK readers face: ‘Management guidance tends to assume the successful implementation of their strategy, which may itself introduce an upward bias.’
- The article further comments that ‘forecasts tend to be based on alternative performance measures (non-GAAP or non-IFRS).’
- Operational forecasts can be faulted because they often ‘ignore certain expense items. It is true that some of these excluded expenses may be truly “nonrecurring” but many more will be “sometimes recurring” or “recurring but volatile.”’
All three of these forecasting faults were present in the problematic business valuation in the US case. The company, founded in 2007, was an importer and distributor of sinks, faucets, plumbing fixtures, and accessories. It conducted online sales through retailers and, showed considerable early growth in sales (from US$21 million in 2012 to US$36 million in 2015). It also had negative cash flow.
The petitioner owned 24% of the company’s shares. The other two owners (individual respondents) held a 25% and a 51% interest. After business relations broke down, the petitioner initially asked for dissolution of the company and damages. Under New York’s BCL 1118(a), the remaining owners elected to buy out the petitioner. The issue at trial was the fair value of the petitioner’s interest as of Sept. 20, 2015, the day before the petition was filed.
Both parties offered testimony from valuation experts who used both an income and a market approach but reached very different value conclusions. Under the income approach, the petitioner’s expert valued the company at US$21.9 million; under the market approach, he arrived at a value of almost US$38.8 million. Averaging the two values, he said the company was worth US$30 million; the value of the petitioner’s interest (undiscounted) was US$7.2 million. In contrast, the respondents’ expert, using a single-period capitalization method and cash flow, valued the company in the range of US$5.9 million to over US$6.1 million; under the market approach, using Pratt’s Stats (now DealStats), he generated a value range of between US$5.3 million and US$6.1 million. Giving greater weight to the income approach, he valued the company at US$6.05 million.
Projections were a major flash point in the valuation proceedings. The petitioner’s expert used a DCF model based on projected earnings the company had used a few months prior to the valuation date to qualify for a bank loan up to US$7 million that could be extended to US$10 million. The petitioner noted one of the respondents, a CFA who served as the company’s controller, prepared the projections. The projections and other representations from all owners to the bank put the value of the company at about US$30 million. The valuer argued the bank relied on this information to grant the loan; he suggested that, therefore, this US$30 million valuation must be credible.
The respondents’ business valuation expert noted that the company had never met a single projection, not in 2014 or 2015. Based on his examination of financial evidence, the projections were not reliable, making the opposing expert’s DCF model unreliable.
The court agreed. The success of the company, as shown by the rapid growth in sales, ‘was not as great as petitioner contended … nor was it accurately predictive of future success or of the true value of [the company],’ the court said. It added that the projections ‘were, put mildly, ambitious, and, in fact, were overstated. In reality, the value of the business was never US$30 million.’
The court declined to comment further on the statements made to the bank or their significance in obtaining the loan. But the court noted, ‘[T]he representations were not accurate.’ It said the respondents’ expert used a sound methodology and provided ‘a realistic assessment’ of the company’s fair value that was consistent with evidence as to the company’s ‘successful business model as well as its debt and cash flow issues.’
Adopting the US$6.05 million valuation and applying a 5% DLOM, the court concluded the petitioner’s interest was worth about $US1.4 million.
Forecast best practices are increasingly focusing on taking all expected values into account. There are many assets and liabilities in IFRS financial statements where measurement is based on estimated future cash flows. Most of these are explicitly or implicitly based on an expected value calculation, but this is not always the case. The Footnotes Analyst considers the many ways management estimates can fool experts:
- 'In some situations, the mode is used and, in others the accounting standards are not very clear, and diversity may arise, affecting the basis of the financial reporting metrics used in analysis and valuation.'
- While market methods take account of the distribution of outcomes (as long as the expert doesn’t bias the result in the selection of comparables), but forecasts often do not. The standards are not very clear here, either. ‘The same applies to most other IFRS current value measures that are not strictly fair values. For example, when measuring an impairment of tangible or intangible fixed assets using the “value in use” approach of IAS 36, there is an explicit requirement that the valuation should be “the weighted average of all possible outcomes.”’
Still many standards demand expected rather than probability-weighted averages during uncertainty—most importantly for business valuers are the expected or most likely value clauses in IFRS 15 Revenue Recognition, and IFRIC 23 Uncertainty Over Income Tax Treatments.
The study by The Footnotes Analyst also provides excellent guidance on how IAS 37 Provisions limits the use of scenario or other probability-weighted analyses when valuing nonfinancial liabilities such as environmental provisions, warranties, restructuring costs, and legal obligations. |
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IVSC Annual General Meeting sessions continue today at noon
Today’s session is ‘The Big Picture: Economic and Market Outlook,’ featuring Sir Paul Tucker, Kathleen Casey, Allistair Darling, and Andrew Tilton. And the Zoom webinar sessions continue over the course of two weeks. The IVSC agenda is available here. Besides public board meetings, meetings of the Advisory Forum, and the formal AGM, there are a number of great virtual panels for business valuers. Including:
- Accounting for Internally Generated Intangibles (Thursday, 8 October at 14:00 BST);
- Recent Trends in Valuing Renewable Energy Portfolios (Friday, 9 October at 15:00 BST); and
- IVSC Standards Boards Update (Friday, 16 October at 11:30 BST).
‘While it is obviously disappointing that we will not get a chance to come together in person, we are excited by the prospect of convening our members, sponsors and supporters from around the world through this online event,’ the IVSC says in a statement. |
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What’s the current UK market risk premium?
Finding—and supporting—a precise cost of capital for UK valuations presents many challenges, but a thoughtful analyses by Reuters at least provides some context. In short, the FTSE lags STOXX by 17%, the pound is more volatile than the euro thanks to the treaty-defying Brexit vote and other factors, and the risk-free rate is more than 20 basis points higher for bank lending compared to the EU.
In other words, the UK’s cost of capital is higher than its neighbours. The Brexit premium is real and may be increasing.
Other risk factors that impact UK business valuations highlighted by Reuters:
- Sterling-implied volatility. Implied volatility (options that show investor expectations of future price swings in a currency) is at five-month highs, at around 12%—'well above implied vol on other G7 currencies.’
- Equity risk. British stocks have underperformed since June 2016, and, as of last week, the FTSE is 17% behind STOXX for the year. Brexit is one reason, but the FTSE reliance on weak sectors is a structural problem.
- The Brexit premium is real. Reuters quotes Justin Onuekwusi, who says, ‘If you look at sector differentials—for instance UK energy or financials versus the rest of the world, you can see an additional risk premium on the UK.’ Onuekwusi is a portfolio manager at Legal & General Investment Management.
- Bank borrowing is more expensive for British companies. ‘For instance, the gap between the yield on Barclays’s September 2023 euro-denominated bond and a Deutsche Bank note maturing the same month has widened of late to the highest in nearly three months around 38 basis points.’ This situation is worsening currently—Reuters quotes ABN Amro analysts who found that spreads on euro-denominated bank bonds widened around three basis points last week—but UK lenders saw spreads worsen by 20 to 30 basis points.
- More money managers expect negative UK interest rates. ‘Money markets have brought forward bets of a Bank of England rate cut, pricing negative interest rates for early-2021,’ the study says. The UK curve is steeper compared to the Bund curve.
- Market-based measures are betting on higher UK inflation. This trend also appeared after the 2016 referendum when the pound crash lifted inflation expectations.
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