A Forecast Requires Some Thought

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This month’s article’s inspiration comes from a different source than most do.  Usually, I have an interesting conversation about some valuation topics and use that to write something that I feel like sharing.  In this case, I am pulling inspiration from an interesting puzzle I have in a valuation project I am working on. 

The business I am appraising has been growing at an increasing rate over the past several years.  The Company has been releasing new product lines and plans on adding at least a couple more over the next couple of years.  I have decided that I need to use the discounted cash flow model to value this business as the Company is not in a mature phase of growth.  The business will likely continue to grow at a strong rate over the next couple of years, but at some point, the growth will have to slow down.  That is one of the first puzzles I must figure out.  How many years out am I going to project? 

That answer is dependent on a variety of factors inherent in the subject business itself.  I am always skeptical of those business appraisal reports I read where the appraiser projected five years before calculating the terminal value.  I simply don’t believe that every company is only ever five years out from stability.  Some will reach that point sooner, and others may take longer.

In this case, there are only two more additional product lines that are expected to be released.  As of my effective date, I believe it will take about two years to see if the individual product lines will be successful, or not, so I have decided to build a forecast out for four years.  That will give me a single year at the point of stability after having launched both new product lines.  Is my choice of a four-year projection the correct answer?  I don’t believe one can truthfully answer that question, but I do believe that it is a reasonable answer.

The next problem I must solve is how to project out the operating expenses.  Some expenses will grow as a percentage of gross revenues, such as the costs associated with purchasing the raw materials required to manufacture the finished product for sale.  Other expenses will likely only increase at a particular rate each year, such as rent and salaries and wages expenses.  Other expenses will vary depending on other factors such as advertising, officer compensation, and depreciation.  Figuring out how these all fit together along with the expected growth in revenues takes some time, research, planning, and often some input from management. 

Once I have figured out the puzzle of the expected future earnings of this company, then the relatively easier phase of simply applying the math to calculate the present value of those future earnings is left to do.  Followed of course by several other methods as checks on my forecast assumptions.  Completing this analysis will take me some time, but it will be very thought-provoking and stimulating time well spent.  Business valuation puzzles are almost always very entertaining!

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