How Experts Assess Forecasts and Projections in a DCF Business Valuation

A DCF valuation estimates the present value of expected future cash flows. The forecast period therefore has a direct bearing on the resulting valuation.

Where projected cash flows are materially higher or lower than historical results, the reasons for the difference may require particular examination.

For example, a forecast might assume:

• Significant revenue growth
• Improving profit margins
• New customer contracts
• Expansion into new markets
• Changes in operating costs
• Increased capital expenditure
• Changes in working capital requirements
• A particular level of recurring or repeat business

Each assumption can affect the projected cash flows and therefore the valuation.

The role of the expert is not simply to accept or reject a forecast. The expert may need to assess the available evidence and determine whether the assumptions provide a reasonable basis for the valuation being undertaken.

The strength of a forecast may depend on the evidence available to support its individual assumptions.

Depending on the circumstances, a valuation expert may consider information such as:

• Historical management accounts
• Statutory financial statements
• Budgets and previous forecasts
• Sales pipelines
• Existing customer contracts
• Order books
• Pricing information
• Customer retention data
• Industry information
• Capital expenditure plans
• Staffing plans
• Board or management reports
• Correspondence concerning significant contracts
• Evidence of actual trading after the valuation date

The relevance of each source will depend on the circumstances of the engagement and the valuation date.

A forecast supported by signed contracts or an established order book may present a different evidential position from one based primarily on anticipated sales that had not yet been secured.

Historical performance can provide useful context when assessing projected results.

An expert may compare forecast revenue, margins, costs, and cash flows with the company's previous trading performance. This does not mean that historical performance necessarily determines future performance.

Businesses can change significantly. A company may have entered a new market, secured major contracts, changed its pricing model, or invested in additional capacity.

However, where a forecast represents a substantial departure from previous performance, the reasons for that change may need to be understood.

For example, if a business historically generated modest annual revenue growth but a forecast assumes a rapid and sustained increase, the expert may examine what evidence supports the change.

The issue is not whether the forecast is optimistic or conservative in isolation. It is whether the assumptions are supported by the evidence available for the particular valuation exercise.

Revenue is often one of the most important components of a forecast.

An expert may examine how projected revenue has been constructed rather than considering the overall revenue figure alone.

Relevant questions can include:

• What existing customers are expected to continue purchasing?
• Are projected sales supported by contracts or established relationships?
• How much revenue depends on new customers?
• Are expected customer numbers consistent with historical experience?
• What assumptions have been made about pricing?
• Are projected sales volumes supported by available capacity?
• Is customer concentration likely to affect the forecast?
• How has the business performed against previous forecasts?

The level of analysis will depend on the nature of the business and the information available.

For a business with recurring contractual revenue, the evidence supporting future income may differ considerably from that available for a business where revenue depends on individual projects or short-term sales opportunities.

Revenue growth does not necessarily translate into equivalent profit growth.

A DCF forecast may therefore require examination of assumptions concerning gross margins, operating expenses, and other costs.

For example, an expert may consider whether projected margins are consistent with:

• Historical margins
• Changes in product or service mix
• Expected pricing changes
• Staffing requirements
• Supplier costs
• Premises costs
• Technology expenditure
• Marketing expenditure
• Other expected operating costs

A forecast may assume that profit margins will increase as revenue grows. That may be reasonable in some circumstances, particularly where there are identifiable economies of scale.

However, the assumption should be considered in the context of the business and the available evidence.

Management may have detailed knowledge of the business and its future plans. That knowledge can be relevant to a valuation.

At the same time, a valuation expert may need to distinguish between management's expectations and assumptions that can be supported by independent evidence.

This distinction can become particularly important where the forecast was prepared after a dispute had arisen or where the forecast has been produced specifically for the purposes of litigation.

The expert may therefore consider the circumstances in which the forecast was prepared, the information available when it was produced, and whether earlier forecasts provide useful evidence about forecasting accuracy.

This does not mean that a forecast prepared for litigation is necessarily unreliable. It means that the circumstances surrounding its preparation may form part of the expert's assessment.

Where information after the valuation date is available, it may sometimes provide useful evidence when assessing assumptions that existed at the valuation date.

For example, actual trading information may show whether particular contracts were secured, whether projected sales materialised, or whether expected costs developed as anticipated.

The treatment of post-valuation-date information depends on the purpose and circumstances of the valuation. An expert should not simply replace the forecast with hindsight.

The relevant question may instead be whether later information provides evidence about conditions or circumstances that existed at the valuation date.

This distinction is important because a valuation should generally be assessed according to the relevant valuation framework and date rather than simply using information that became available later.

Growth assumptions can have a substantial effect on a DCF valuation, particularly where growth is projected over several years.

An expert may therefore consider:

• Historical growth rates
• Market conditions
• Capacity constraints
• Competitive conditions
• Customer demand
• Pricing assumptions
• Planned investment
• Industry growth
• The maturity of the business

A high growth rate may be more plausible for a relatively young business operating in a rapidly expanding market than for a mature company in a stable or declining market.

The appropriate assessment will depend on the evidence and characteristics of the business.

A DCF valuation may include a terminal value representing the value of cash flows beyond the explicit forecast period.

This means assumptions about long-term growth can have a significant influence on the overall valuation.

An expert may therefore examine whether the long-term assumptions are consistent with the nature and prospects of the business.

A long-term growth assumption should not necessarily be treated as a simple extension of short-term forecast growth. A business may be expected to grow rapidly during an initial period and then move towards a more stable level of growth.

The relationship between the forecast period, terminal value, and long-term assumptions can therefore require careful consideration.

A valuation expert may also consider how changes to key assumptions affect the valuation.

Sensitivity analysis can illustrate the effect of changing assumptions such as:

• Revenue growth
• Profit margins
• Discount rate
• Working capital requirements
• Capital expenditure
• Long-term growth

This can help identify which assumptions have the greatest influence on the valuation outcome.

Sensitivity analysis does not, by itself, establish which assumption is correct. It can instead help demonstrate how dependent the valuation is on particular inputs.

For litigation purposes, this may assist the court or parties in understanding the significance of disputed assumptions.

Forecasting future performance inevitably involves uncertainty.

The level of uncertainty may vary depending on the business. A company with long-term contracts and predictable recurring revenue may have different forecasting characteristics from one that relies on irregular projects, a small number of customers, or rapidly changing market conditions.

A valuation expert may therefore consider the risks associated with the assumptions rather than treating every forecast input as equally certain.

This assessment can be relevant to the overall valuation methodology, including the consideration of the appropriate discount rate and other valuation inputs.

The quality of the valuation analysis can depend partly on the information provided to the expert.

Depending on the case, potentially relevant material may include:

• Historic statutory accounts
• Management accounts
• Budgets
• Previous forecasts
• Current forecasts
• Business plans
• Customer contracts
• Order books
• Sales pipeline information
• Management information
• Capital expenditure plans
• Relevant correspondence
• Information concerning material changes to the business

The expert's instructions should also make the relevant valuation date and purpose of the valuation clear.

Where there is a dispute about particular assumptions, identifying those issues at the instruction stage can help the expert understand the questions that the valuation evidence is expected to address.

For guidance on instructing an expert, see How to Instruct a Business Valuation Expert Witness.

A DCF valuation can be sensitive to assumptions about future performance. The credibility of those assumptions can therefore be an important part of the valuation evidence.

A properly considered analysis should explain the basis for material assumptions and identify the evidence supporting them where appropriate.

For solicitors, the important issue is not simply whether a business valuation uses a DCF model. It is how the projected cash flows have been constructed, tested, and assessed in the context of the evidence.

The DCF and maintainable earnings guide provides further context on the choice between valuation approaches and the assumptions that can become disputed between experts.

The site's DCF valuation methodology guide also explains the principal components of a DCF valuation, including projected cash flows, the discount rate, and terminal value.

Where forecasts are central to the valuation, an appropriately qualified business valuation expert can assess the assumptions, identify areas of uncertainty, and explain the effect of key inputs on the valuation conclusion.

Forecasts are an important component of many DCF business valuations, but their inclusion does not mean that every projected figure should automatically be accepted.

A valuation expert may assess forecasts against historical performance, available commercial evidence, contracts, customer information, costs, market conditions, and the circumstances surrounding their preparation. The expert may also consider the effect of key assumptions through appropriate sensitivity analysis.

For solicitors dealing with a business valuation dispute, understanding how forecasts are assessed can help identify the evidence that may be relevant to the expert's work.

Where the valuation depends materially on projected future cash flows, careful examination of the assumptions behind those projections can be an important part of producing clear and properly supported valuation evidence.