Is the valuation based on a going concern income-based approach? If so, what future cash flow assumptions are the value conclusions based upon?
The reasonableness of the underlying cash flow assumptions can significantly affect the integrity of the resulting value conclusions. Under common income-based valuation approaches, the business valuator must select an operating cash flow level (or range) that he/she expects the business to generate going forward. The cash flows may vary from year to year over a specific projection period or an ongoing maintainable level may be assumed.
Step 5 to reviewing a business valuation report involves assessing the reasonableness of the projected cash flow assumptions.
To recap, an income-based approach involves estimating the present value of the projected future cash flows to be generated from the business and theoretically available to the capital providers of the company. A discount rate is then applied to the projected future cash flows to arrive at a present value.
Two common income-based approaches include the discounted cash flow (DCF) approach and the capitalized cash flow (CCF) approach. A brief discussion of each approach along with some key items to consider in assessing the reasonableness of the projected cash flow assumptions is set out below:
Discounted Cash Flow Approach (DCF)
The DCF approach involves estimating the present value of the projected future cash flows to be generated from the business. A discount rate is applied to the projected future cash flows to arrive at a present value. The cash flows are typically projected over a limited number of years (e.g. 3 to 5 years) and a terminal value is determined as at the end of the projection period based on an assumed annual cash flow at that time.
Items to consider in assessing the reasonableness of the projected cash flows include:
- Time period – a longer period is more difficult to accurately predict
- Revenue growth rates – supported by actual historical rates and/or industry averages?
- Gross profit margins – consistent with past performance and/or industry averages?
- EBITDA margins – consistent with past performance and/or industry averages?
- Capital reinvestment – sufficient to meet revenue and cash flow growth?
- Working capital requirements – often overlooked but necessary to support revenue growth
Where cash flow projections are provided by management, the valuator should assess the reliability of management’s projections including the ability of management to accurately predict future cash flows. This can be done by comparing actual historical results to management’s original projections for the same period of time.
Capitalized Cash Flow Approach (CCF)
The CCF approach involves converting an annual maintainable cash flow (e.g. discretionary cash flow, EBITDA, etc.) into a lump sum present value using a capitalization rate (or valuation multiplier) that reflects the risk profile and long-term growth prospects of the company. Under this approach, historical results serve as a proxy for the company’s future performance. As a result, the valuator must "normalize" the company’s historical cash flows so they provide the best representation of what the company is expected to generate going forward.
Items to consider in assessing the reasonableness of the projected annual maintainable cash flows include:
- Normalization items - have all normalization items been considered and appropriately reflected?
- Trends – has there been an increasing/decreasing trend in the past normalized cash flows?
- Past as an indicator – is the past truly representative of the company’s future?
- Weighting – should certain years be more heavily weighted than others?
- Changes – have there been recent changes in business strategy, product mix, customers, contracts, suppliers, employees, etc.?
Some of the more common normalization adjustments you can expect to see include:
- Shareholder remuneration – should be adjusted to market wages for services provided
- Related party payments (e.g. wages, rent, etc.) – should be adjusted or imputed to market amounts for services provided
- Personal and/or discretionary expenses - should be added back
- Non-operating income – income from redundant assets should be deducted
- One-time, non-recurring items – revenues should be deducted and expenses should be added back
Reasonable and supportable future cash flow assumptions are critical to a reliable value conclusion. Depending upon the scope of review, inquiries and experience level, this is an area where business valuators can differ significantly. As a result, assessing the reasonableness of the projected future cash flows or the normalized historical cash flows and resulting selection of maintainable cash flow should be a major focus in reviewing a business valuation report.
If you have any questions regarding assessing the reasonableness of cash flow assumptions or if you would like an independent business valuator to assist in your review of a business valuation report, contact us at www.vspltd.ca.