Chapter 12 The Role of Projections and Uncertainty in Valuation

• Jurisdiction: United States

Chapter 12: The Role of Projections and Uncertainty in Valuation

A. Cornerstone of Financial Decision-Making: Credible Projections

Projecting a company's future performance is one of the most important functions for healthy, distressed or bankrupt companies. Numerous business and financial decisions are based on an estimate of future performance. The authors' experience, however, indicates that many companies do not have well-developed financial projections.

For example, consider the leveraged buyout of a large transportation company. The company was acquired by a team of recent graduates of an Ivy League business school. The energetic management spent significant effort on improving the operations and logistics of the company. They implemented a large number of concepts taught in business schools around the country, such as just-in-time (JIT) and total quality management (TQM). They also spent considerable effort micro-managing costs in the business and relocating the company's hubs. Similarly, board meetings focused on restructuring the company's operations and reshaping its organization chart. However, well-reasoned and well-supported projections were not discussed in board meetings.

The first time the issue of lack of liquidity was mentioned was three weeks before the company filed for bankruptcy. Clearly, management never used a set of projections to assess whether the operational measures it implemented could be funded. The case of a board of directors only realizing its financial distress three weeks before bankruptcy is the ultimate example of what happens when a company neglects to regularly develop and revise the company's projections.

Analysts understand the importance of developing a reliable set of financial projections for the professionals involved in distressed and bankrupt companies. Projections are the cornerstone of many distressed and bankrupt company decision-making processes, including:

• the assessment of whether the company is better off to the stakeholders dead or alive;
• business and security valuations to be used in valuation hearings;
• the assessment of the size of the overall bankruptcy estate pie to be distributed among the various stakeholders;
• the determination of the amount of debt that the debtor company can reasonably assume and be able to service post-reorganization;
• decisions by claimants as to whether to elect an equity-based share with upside potential or a more certain, lower-priority debt; and
• a confirmation that upon post-reorganization, the debtor company will be a viable going-concern entity.

Similarly, for healthy companies, strategic, as well as critical, day-to-day decisions are based on the company's financial projections, including the following:

• the determination of the size of the capital expenditures budget;
• decisions about the company's credit policy;
• the evaluation of acquisitions and divestitures;
• a determination of the company's capital structure; and
• the launching of new products and services.

Whether the company is healthy or distressed, a few things have to be determined with respect to developing a set of financial projections. The analyst will typically consider the sources relied upon in the projection process, the methodologies applied and the reasonableness of the projections.

Sources of Information

If possible, management should encourage wide participation in the projections process from different departments across the organization. For example, the sales and marketing department may have projections that assume the sale of a certain quantity over the next five years. However, the company's current manufacturing capacity may not be able to produce the quantity that was projected by the sales and marketing department. Consequently, interaction among the various functions results in projections that are more feasible and forces the departments to communicate and share information. A decision then has to be made as to whether the primary projections are based on internal sources, external sources or both.

Internal Sources

Internal sources are based on all information within the debtor company. Management should encourage the orderly maintenance of historical data and trends. In the authors' experience, a large number of clients express very little interest in historical data. However, historical data can be used to analyze the primary drivers of the company's performance, both for preparation of the projections and the assessment of the reasonableness of the projections.

With adequate historical data, management can perform various analyses, which can be as simple as trend ratios or as complex as statistical analyses, such as regressions. Moreover, a rich database of historical information can also help determine the reasonableness of past projections at the time that they were made. For example, in the recent acquisition of a utility company, as part of its projection package, the acquiring company presented the results of its previous acquisitions compared to the projections made at the time of those acquisitions. The fact that the actual post-acquisition performance of the acquired company was very close to the projected performance enhanced the credibility of the financial projections for the current acquisition.

In order to develop a set of supportable projections, a thorough understanding of historical performance is required. Although one should not assume that historical performance will necessarily be replicated in the future, an analysis of historical data can often serve as a basis for both the preparation of the projections and the assessment of the reasonableness of the projections. Below are examples of these types of analyses.

Income Statement Analysis

• Sales: historical sales, customer mix, concentration of sales, product mix, geographical segmentation, etc.
• Cost Structure: variable costs vs. fixed costs, key raw materials inputs, primary technology relied upon, overhead expenses, research and development, etc.
• Margins: gross margins, operating cash-flow margins, operating-income margins (as defined by the company), etc.
• Financing Costs: interest expenses, review of the loan agreements for projecting interest rates, etc.
• Taxation: effective income tax rate, review of net operating losses (NOLs), etc.

Balance Sheet Analysis

• Working Capital: accounts receivable, accounts payable and inventory.
• Fixed Assets and Intangibles: capital expenditures, useful lives of assets, depreciation and amortization expenses.
• Debt: amounts and timing of debt maturities.

Cash Flow Statement Analysis

• Primary Sources and Uses of Cash: cash flow generated by or utilized in operating activities, investing activities and financing activities.

Other Sources

Other sources to review depend on the internal reports available at each company. The reports vary from company to company and industry to industry. Examples of such reports include accounts receivable aging reports, order backlog reports, sales reports, inventory aging, doubtful debts, factoring reports, etc.

In addition to the basic maturities and interest rates, analysts will typically review loan covenants, which provide insight into various constraints as to working-capital levels, minimum cash, capital expenditures, leverage ratios and dividend payouts. One has to ensure that the projections are compatible with these loan covenants.

When developing financial projections for a company engaged in fraudulent activities, the use of internal sources of information prepared by management is often more limited. For example, consider a recent case that the authors worked on where projections for a communications company were developed. The company issued a statement that all of its historical Securities and Exchange Commission (SEC) filings could not be relied upon. Moreover, following the revelation of fraud, it was discovered that virtually every aspect of the company's operations was misstated, including its sales, profitability, debt, assets, equity and the state of its technology. In such a case, one cannot necessarily rely on internal sources.

In another case, the authors were asked to provide an independent valuation of a company at which certain shareholders would buy out other shareholders. Although both groups were considered to be intimately familiar with the company, the financial projections pro-

vided by these two groups were materially different. While judgment should be applied by the professional analyzing projections in every case, this particular case necessitated extensive due diligence to narrow the gap between these two sets of projections.

External Sources

The advantage of internal sources of information is that the information is generated by people involved in the company's operations. The potential disadvantage is that these individuals may be too deeply involved in the day-to-day operations and therefore might have difficulty seeing the "big picture." It is often useful to draw on external sources to develop a set of financial projections. The following are examples of these sources.

Economic Indicators

Often, analysts can correlate the historical performance of a company to the level of activity in its industry. Similarly, a company's performance can be compared to economy-wide indicators. The relevant economic indicators vary from industry to industry, and certain industries are more sensitive to interest rate fluctuations while others may be more dependent on the housing market. Other relevant indicators may include gross domestic product (GDP), disposable income, foreign exchange rates, commodity...