Financial forecast or Prospective Financial Information (PFI) is the key element of most business valuations. It is a numerical illustration, a distillation of the story that investors buy into. With that, valuation analysis is nothing more than a process of converting the expectations into hard reality of today’s market price.
Income approach commonly relies on long-term projections for valuing business interests or individual assets. A comprehensive application of market multiples requires one to two years of PFI as well. For example, very little work can be done in purchase accounting valuations (ASC 805) without a solid long-range P&L forecast.
A detailed and thoughtfully prepared PFI is a requirement for a properly prepared and auditable fair value analysis under US GAAP and IFRS. Valuations struggle to pass any serious audit review without it. While valuation specialists must follow a certain set of procedures around client provided PFI, it is always the client’s responsibility to prepare and defend it in front of reviewers.
1. What goes into the right PFI
Since we last wrote about PFI, the non-authoritative procedures were formalized within Mandatory Performance Framework (MPF). Sorbus fully supports, works hard to follow, and views MPF as a minimal starting point in its valuation engagements.
MPF lists elements of a forecast to be provided by a client:
Base year metrics ♦ Revenue forecasts or revenue growth rates ♦ Gross margins ♦ EBITDA/EBIT margins ♦ Depreciation and amortization (book and tax) ♦ Effective tax rate ♦ Capital expenditures ♦ Debt-free net working capital (DFNWC) requirements ♦ Other metrics where applicable.
We may also ask for:
◊ Bifurcating operating expenses into research and development, sales and marketing and G&A.
◊ Some of the biotech companies would have to provide probabilities of success and timing of the clinical development phases [Sorbus can offer some of this data].
◊ Because of the complexities of the new tax law, we encourage clients to provide a detailed tax expense forecast that takes into account new tax rates, NOL treatment, and accelerated tax amortization.
We often assist our not-capex-intensive technology, life sciences, and consumer product client with forecasting capital expenditures, depreciation, and DFNWC.
2. What Should Valuation Specialist Do
Valuation analyst must scrutinize the forecast to assess its relevance to the current market participant view of the subject interest’s financial future. MPF points to the following:
♦ Mathematical and logic check. Audit procedures often require higher mathematical accuracy than those in the context of in-house consumption. Valuation specialist will check the summary P&L, but not every page of the underlying Excel workbook.
♦ Comparing PFI to historical trends. More established businesses have to leverage their historical performance in preparing and supporting PFI.
♦ Comparison to peer performance. Financial performance of guideline public companies can support assumptions behind revenue growth, profitability, capital expenditures or DFNWC.
♦ The frequency of preparation. The best forecasts are those prepared periodically and consistently as part of the internal FP&A, or those commissioned from a third-party specialist.
♦ Comparison of a prior forecast and actual results. Consistent under- or overperformance relative to the budget may highlight management’s bias and help valuation specialist interpret new PFI.
♦ In valuing intangible assets, comparing PFI for an underlying asset to PFI for the subject entity. Valuation specialist would have to seek out other reasonable indications of consistency among various elements of the forecast, not just summary revenue or EBIT comparisons.
3. PFI Red Flags
We find that the forecast is not fully tested until discounted cash flow (DCF) analysis is completed. With all the flexibility afforded by a highly subjective discount rate or terminal value assumptions, poorly prepared PFI would result in absurd value conclusions. Our DCF calculations commonly flag PFI that is:
Excessively optimistic or pessimistic ♦ Prepared for the purposes of selling the company or inspirational to its sales force ♦ Prepared to track cash burn or debt service ♦ Product line contribution P&L not fully burned with all relevant overheads ♦ Unsupportable terminal year P&L.
4. PFI recommendations
We recommend preparing the forecast that is:
A) Reasonably optimistic,
B) Prepared based on non-financial drivers such as the number of units sold, market share, product pricing, and costs segregated by their nature and tied to a specific operating road-map,
C) In the purchase accounting context, outlines buyer specific and market participant synergies, separately,
D) Consistent with the cost structure of its peers,
E) Consistent with the company’s historical performance,
F) At least 5 years long,
G) Revised periodically with updated views on the key drivers.
Finally, always discuss PFI requirements with your valuation specialist, especially if you have to prepare it for the sole purpose of a valuation engagement.