Predicting the Future: The Role of Forecasts in Business Valuations | Marcum LLP

Your business has grown steadily over the years, but you expect even more growth in the coming years. This could be due to an acquisition, securing a new client, adding a location, more operational capacity, or expanding product/service lines… the reasons are endless. Whatever the catalyst, one thing is clear, your past financial performance may not be a reliable indicator of your expected future operations. And when that’s the case, forecasts are integral to understanding the value of your business.

Forecasts are generally based on a combination of the company’s historical financial performance, industry and economic trends, and management’s future strategic plans. Key elements of the forecast include revenue growth, gross profit margins and operating expenses (including depreciation and interest). Other important factors relate to the capital expenditure required to support expected growth and changes in net working capital. Each will take into account the business’ projected future cash flows and ultimately value.

Here are some key points to consider when preparing and providing forecasts for evaluation purposes:

  • Prepare notes on the main factors that drive your predictions. Valuation isn’t just about the numbers, it’s about understanding the narrative behind the numbers. Provide information on what was considered in determining revenue growth, gross profit margins, operating expenses, etc. Forecasts are only as reliable as the assumptions they are based on. Providing compelling reasons for expected growth and profitability tells a story beyond the numbers on the page.
  • Perform a reasonableness test by comparing projected results (especially growth factors and profit margins) to the company’s historical data. Are the forecasts more aggressive, conservative, or in line with the company’s historical trends? Overly optimistic assumptions can inflate a company’s value, while pessimistic assumptions can lead to undervaluation.
  • Track your predictions against actual results to help you make future predictions. For example, if you have prepared forecasts for the calendar year 2023, after the year is over and the company’s financial statements are complete, compare the actual results with the forecast. How close were the forecasts to actual activity? What happened or didn’t happen that made the difference? Were you overly optimistic or pessimistic?
  • Forecasts may be revised over time to reflect new information and changes in the business environment. Depending on the company, this can be done annually, quarterly, or even monthly. From an evaluation perspective, note that it is important to understand when the forecasts were developed. Once the project is finalized and approved by management, mark the date it was completed. From there, save new versions of the revised forecasts with updated completion dates.

Other evaluation considerations

  • Date of assessment – Estimates and factors affecting the estimates must be known or known as of the selected valuation date. Based on the valuation standards, the valuation analyst may consider only events and conditions that occurred before and on the valuation date, but not those that occurred after the valuation date, if they were not known or known thereby time. The existence of forecasts prepared before the date of the assessment ensures that knowledge after that date has not been used in their preparation.
  • Potential future acquisitions – Accounting for potential future acquisitions in your forecasts is challenging from a valuation perspective, especially since knowledge of the purchase price required to acquire the revenue and profit associated with the acquisition is usually unknown. Focusing on the company’s existing operations and known future plans as of the valuation date will give you a more accurate estimate of the company’s value.
  • Specific company risk – It is essential to review your forecasts against your company’s historical performance. Are forecasts particularly aggressive, pushing revenue and profit margins higher than what the company has been able to achieve in the past? How do these growth rates and profit margins compare to others in the industry? More aggressive forecasts can result in a higher company-specific risk adjustment, which increases the discount rate and in turn lowers the company’s value. The risks and uncertainties in the forecasts, as well as the company as a whole, will be factored into the discount rate used in the valuation analysis.

While historical financial data lays the foundation for understanding a company’s operations, it may not capture the expected future growth of the business. Well-supported financial projections provide insight into a company’s expected future growth and profitability, which can lead to a more accurate company value. When developing forecasts, keep in mind that they must be based on reasonable and acceptable assumptions and reflect both the opportunities and risks facing the company.

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