How many of us have had a perfectly planned vacation turn into something completely unexpected? Imagine having everything packed, a full tank of gas in the car and restaurants already chosen. You get into the car and drive a few hours down the road only to hit unfavorable weather conditions, a car accident and road closures. You haven’t even made it to your final destination point – who knows what may happen once you arrive!
Similar to this perfectly planned, yet unfortunate trip, valuation experts encounter a similar issue called projection risk. How does a valuation take into account that any number of unknown factors may intervene and throw a company off track for its projections? Oftentimes, the risk associated with management achieving its projections is reflected as an adjustment to the discount rate used in valuing a company – the greater the risk of achieving the projections, the higher the discount rate.
While the extent of the adjustment to the discount rate for projection risk is subject to professional judgment, the risk of management meeting its projections can be analyzed in a handful of ways:
- Historical Budget-to-Actual Performance – Analyzing how well a company performed against its budgets and projections in the past can provide insight as to the likelihood of management meeting its future projections.
- Projection Analysis – Do the projections make sense in relation to the company’s historical operations? Are projected revenues, margins, working capital levels and capital expenditures consistent with the company’s historical activity?
- Industry/Economic Analysis – Do the projections make sense in relation to the expectations for the company’s industry and the overall economy? High growth industries lend themselves to more aggressive growth projections, and vice versa.
Projection risk is meant to account for the risk of management meeting its projections. Just like planning a vacation, any number of issues may pop up over time that throws the company off of its projected course. Consideration of the factors above, however, can allow a valuator to take into account the potential for a company to deviate from its projections while providing a foundation for determining the impact of projection risk on the company’s value.