A recent engagement reminded me of some important lessons about preparing a forecast for client review (when the client does not prepare their own).
I was doing an annual ESOP valuation for a company that has had a tough year because of extraordinary circumstances (a lawsuit) that caused it to suffer big but temporary revenue and earnings declines. In previous years it had grown nicely and had always been profitable. Due to the lawsuit, the bank cancelled the Company’s line of credit, which had been used to fund seasonal intra-year cash shortfalls. The Company, expecting the lawsuit, had accumulated significant cash (about $2 million) anticipating the loss of its credit line. The lawsuit has now been settled, with minimal cost to the client, but this was not known or reasonably knowable as of the valuation date.
The first lesson: if you are valuing cash flow to equity (or invested capital), do not just blithely add 100% of valuation date cash to the (discounted / capitalized) benefit value. I explored with the client how much cash was necessary for normal operations (in the absence of a credit line) and we determined that about half, or $1 million, was truly needed to take the place of the line, so only half of the cash on hand, or $1 million, was truly excess as of the valuation date and added to the benefit value.
The second lesson: guide the client as to which assumptions have the greatest impact on the overall valuation. These are the ones you really need them to verify. In this case, the business had always had very low (on the order of 1 to 2%) operating profit margins, and most of its costs were variable with revenue. The lawsuit and associated expenses created a net loss for the Company last year, which quite naturally was disturbing to the client. Due to my own stupidity, I neglected to mention to the client that, given these facts:
A. The valuation was relatively insensitive to the levels of projected revenue, because of low margins.
B. Earnings (operating and net income) were very sensitive to the gross profit margin assumption: a change of 0.5% in margin had a huge impact (e.g. whether the Company would be profitable or unprofitable). Operating expenses were very stable and small, so these were easy to forecast with reasonable certainty and not sensitive.
C. Most of the value of the equity was represented by the excess cash (of $1 million).
D. Because of this, the overall valuation was NOT that sensitive to the gross profit margin assumption, even though it had a great impact on earnings.
Because I did not make this clear to my client, they spent a great deal of time fussing around with my original financial forecast (mainly the income statement: revenue and margin assumptions), even though their ultimate impact on the total value was minor.
The third lesson: the client’s seemingly unnecessary focus on the income statement assumptions had a HUGE benefit! Previously, they had just looked at my forecast on a total company basis (what I called a “top down” view). I would project (say) revenue growth of 5% and margins of 1% for the total company, and they would bless or revise that. In this valuation, they dug down and broke their business into four separate units, analyzing and projecting revenue and margin for each one. This was what I called a “bottom up” approach, and it showed them that one such unit was, despite significant revenue, not contributing very much at all to the bottom line. They combined the business unit forecasts and compared and reconciled the bottom-up and top-down projections. This dramatically enhanced their (and my) understanding of the finances of the company, and was also very persuasive to their bank, which has since restored their line of credit. The bottom line: a bottom up projection reconciled with a top down projection makes the forecast even more plausible.
So, to recap: analyze how much cash is really excessive, guide your client as to the value-sensitive assumptions, and urge them to do bottom-up as well as top-down forecasts!