I have always been intrigued by magic. It is not often that a magician reveals his secrets, but I recently watched a movie, Now You See Me, in which the magicians actually revealed the secret to their performance. In an early scene of the movie, a volunteer from the audience at a magic show in Las Vegas is transported across the globe into a bank vault in Paris. Later, it is revealed that the volunteer was not actually transported, but simply dropped through a trap door into an exact replica of the bank’s vault. In a similar way, business valuation can seem quite mysterious to the untrained eye, but behind the scenes, valuation experts are using logical and supportable inputs to reach concluded values.
Financial projections, discount rates and discounts for lack of marketability are few examples of key inputs to a business valuation that may seem puzzling. Here are some other common, valid questions asked by clients who are unfamiliar with valuation:
- How does the valuation analyst know what amount of revenue the business will generate five or ten years from now?
- How does the valuation analyst know what expenses the business will incur in the future?
- Why are future cash flows being discounted to present value at a rate of 15% or 20%?
- Why is there a discount for lack of marketability and how was it calculated?
These are all common and valid questions that may be asked by a client or other user of a business valuation who is not familiar with the application of valuation methodologies.
Most of the time, a valuation analyst will use projections provided by management to develop estimates for future revenues and cash flows. However, the valuation analyst should scrutinize the validity of management’s projections by comparing them to the company’s historical financial performance, comparable guideline public company financial performance, and expectations of the industry and economy to ensure that the projections are reasonable.
If management forecasts revenue growth that is double the company’s historical growth rate and significantly higher than projected industry growth rates, the valuation analyst will interview management to determine if such growth is reasonable and how it will be achieved. The company may have plans to expand into new geographic markets or make strategic acquisitions to achieve the projected growth. On the other hand, the projections may be unreasonable and need adjusting. In either situation, substantial analysis is performed before relying on the projections – they are not magically created by the valuation analyst.
A discount rate may seem mysterious to someone without some background in finance. The discount rate is used to calculate the present value of expected future cash flows. This is an important concept because receiving one dollar is worth more today than receiving that one dollar at some point in time several years from now. But how does the valuation analyst know what discount rate to use? The rate is built based on empirical data starting with the risk free rate, incorporating an equity size and risk premium, and adjusting for specific company risk. These inputs are based on financial data and are supported by extensive financial analysis.
Discounts for lack of marketability have been a topic of debate in court and in the valuation community for many years. The discount for lack of marketability should always take into account company-specific factors and the extensive marketability studies that have been conducted by many financial experts over the past 50 years. Similar to the previous examples, the discount for lack of marketability is not selected haphazardly. In fact, there is a push in the valuation community for more quantitative analysis when selecting the appropriate discount for lack of marketability.
While these are just a few business valuation inputs that may seem obscure and there are certainly others. Once the curtain is pulled back, however, there really are no secrets. Every input that goes into a business valuation must be logical and supportable. These inputs are often scrutinized by the IRS, auditors, or opposing parties in litigation, making it important for the valuation analyst to complete a thorough analysis and support all of his inputs. Unfortunately for entertainment purposes, there is no real magic in a business valuation.