Appraisal reports should discuss the implications of the underlying economic, industry, and company analyses for the valuation of the subject business and interest. If we do not do this, these sections appear to float untethered to the valuation analysis, and may be shown to conflict with our financial forecasts and / or cost of capital estimates.
I have found it very helpful, at the end of the economic, industry, and company analysis sections of my reports, to discuss what each one implies for future:
● Revenue growth
● Operating profit margin
● Financing cost
● Business risk (volatility of operating income)
● Financial risk (of insolvency or bankruptcy)
The first three support my financial forecast and the last two support my cost of capital estimate.
The Crash of 2008 and the subsequent contraction of bank credit have led me to expand the third implication to consider:
● Financing cost and availability
During the years preceding the Crash, lending standards became increasingly lax. Loans were made to all but the very worst credits (and even some of those). Lenders are much more wary now, and it is dangerous to blithely assume that a business can borrow whatever it desires. In my hometown of Cleveland, banks are really picky about extending existing and offering new loans. It is one more thing I have to check out.
This is especially important if you use the weighted average cost of capital. This methodology, by itself, places no constraint on how much a business can borrow. (This is because it is based on a ratio of debt to equity, or a percentage of debt to total capital. As equity rises, debt is assume to rise proportionately.) If there is a debt limit, you have to check to see that it is not exceeded.
Here is a case in point. Several years ago I reviewed the valuation of a highly distressed company prepared by another firm. The subject company was on the verge of having its loan called because it was unprofitable, cash-flow negative, and in violation of many loan covenants. The appraiser, however, using the unconstrained WACC, implicitly assumed that the company, which was growing, could borrow additional capital at the going rate of interest. When I pointed this out, the appraiser realized the error, and had to rework their opinion accordingly, resulting in a vastly lower value conclusion.
The moral of the story: check out financing cost and availability!