The financial forecast is the basis for most valuation engagements. Through the magic of valuation science, management’s outlook is combined with financial-market-derived discount rates to produce a reasonably accurate valuation. The effectiveness of this approach is demonstrated by the countless transactions that have been priced using the same methods.
In financial reporting, the army of subjective valuation assumptions can help compensate for a poorly prepared forecast – but only to a degree. Below are a few thoughts about the Prospective Financial Information (PFI).
A centerpiece of the valuation analysis, long-term PFI has to be contemporaneous to the valuation date, diligently prepared, and representative of most likely future financial performance. A good forecast will consider historical performance, commercial product outlook, and financial results of comparable businesses.
Too often, even most creative valuation analyst cannot make up for bad PFI. Problems may arise with sell-side forecasts or with best-case or worst–case scenarios. In purchase accounting, we look out for highly conservative forecasts or those that only incorporate marginal contribution from the acquired entity without taking into account the acquirer’s corporate cost structure or what upfront costs may be required to scale the business.
PFI has to be well supported. A forecast can be developed based on ground-up analysis of market size, market share, product pricing, and cost to build and maintain ongoing operations. Alternatively, PFI can be developed based on trends in customer retention/growth, product pricing, and operating expenses, while also considering market forces and new product development to support growth. Data takes precedence over management’s judgement when supporting underlying assumptions. Sufficiently detailed PFI will facilitate both valuation and audit, not to mention improve internal strategic planning.
PFI has to be a forecast, not a set of actual financials. This dilemma may occur when the valuation analysis is performed long after the valuation date. In principal, valuations are based on uncertain expectations adjusted for risk. Inserting actual financial results does not improve the analysis; instead, it renders valuations meaningless.
In contrast, audit best practices place reliance on the actual results when reviewing PFI for reasonableness. The best approach to address this pretzel-shaped logic is to reference contemporaneous documentation, e.g. old strategic plans, or to maintain a detailed forecast that can explain, in operating terms, the difference between forecast and actuals.
PFI can be different depending on the purpose of the valuation. In purchase accounting (ASC 805) PFI should consider acquisition synergies, while most common stock valuations require PFI that represents company performance under current ownership. Valuation specialists should be able to provide guidance as to what assumptions are appropriate under various circumstances.
In the financial reporting environment, management develops and auditors scrutinize PFI. Even though a valuation specialist does not take responsibility for PFI, he or she should help management select the appropriate forecasting framework, consider PFI’s overall reasonableness, and identify potential red flags in order to achieve the most meaningful valuation analysis and a swift audit review.