Understanding Projections and the Discounted Cash Flow Method

An initial step in any business valuation engagement tasks the valuator to identify the valuation approach and methodology. One of the most commonly used valuation methods is the discounted cash flow (“DCF”) method of the income approach. The DCF method assigns value based on expected future earnings or cash flow of the business, discounted to present value using a discount rate that is commensurate with the risk of the projected performance. This method can be more flexible as it allows for variation in growth rates, debt repayments, margins and other items that may not remain static in future years.

One of the most important inputs to the DCF is the projected future cash flows. These projections are typically provided by the company’s management team and/or investor group. In most circumstances, this group knows more about the company, its products/services and customers, so they are often positioned to provide the most accurate expectations regarding future financial activity.

A valuation expert should make every effort to understand management’s projections when future activity is significantly different than historical activity and should ask management to explain the following items among others:

• What is driving increases/decreases in sales?
• What is driving increases/decreases in profitability?
• Have the necessary capital expenditures been considered to achieve projected sales growth?
• Can the company’s current workforce and infrastructure support the forecasted growth?
• How does the projected financial activity align with macro expectations and the expectations of other market participants?

The answers to these questions will help the valuator estimate the risk in the projected financial results. After gaining an understanding of the logic within management’s projections, the valuation analyst should take some additional steps to assist in developing an appropriate discount rate. These steps should include the following among others:

• How good has management been at projecting future results in the past?  Does the company typically meet or miss budgeted results?
• Compare the forecasted financial activity to guideline public company activity. Analyze profitability metrics and capital spending levels of guideline public companies to determine if management’s projections are reasonable.
• Valuators should also be aware of the implied returns demanded by the investor community for similar companies.
• Do management’s projections include significant growth into perpetuity?  Projected growth and profitability improvement should temper to a steady-state level in-line with long-term expectations for the subject industry and macro expectations before applying perpetual assumptions.

Considering these factors, among others, can help the valuation expert determine how much risk is inherent in a given projection. Understanding this risk helps determine the magnitude of an applicable discount rate. More risk equals higher discount rate and vice versa.

Projecting future cash flows and determining the appropriate rate at which to discount those future cash flows are difficult tasks for both management and the valuation expert. No one can predict the future, but it is important to consider the factors discussed above to provide reasonably supported indications of value.