Forecasting the Future: The Role of Projections in Business Valuations

Your business has been growing steadily over the years, but you expect even more growth in the years to come. That may be due to an acquisition, securing a new client, adding a location, more operating capacity, or expanding product/service lines… the reasons are endless. Whatever the catalyst, one thing is clear, your past financial performance may not be a reliable indicator of your anticipated future operations. And when that’s the case, projections are integral to understanding what your business is worth.

Projections are typically based on a combination of a company’s historical financial performance, industry and economic trends, and management’s future strategic plans. The key elements of a projection include revenue growth, gross profit margins, and operating expenses (including depreciation, amortization, and interest). Other important factors relate to capital expenditures necessary to support the expected growth and changes in net working capital. Each of these will factor into the business’s projected future cash flows, and ultimately, value.

Here are some key points to consider when preparing and providing projections for valuation purposes:

• Prepare notes on the primary factors driving your projections. Valuation is not only about the numbers but also about understanding the narrative behind the numbers. Provide background on what was considered when determining the revenue growth, gross profit margins, operating expenses, etc. Projections are only as reliable as the assumptions on which they are based. Providing supportable reasons for anticipated growth and profitability tells a story beyond the numbers on a page.
• Perform a reasonableness test by comparing the projected results (particularly growth factors and profit margins) to the company’s historical data. Are the projections more aggressive, conservative, or in line with the company’s historical trends? Overly optimistic assumptions may inflate the company’s value, whereas pessimistic assumptions may lead to undervaluation.
• Track your projections against actual results to aid you in preparing future projections. For example, if you prepared projections for calendar year 2023, once the year wraps up and the company’s financials are complete, compare the actual results to what was projected. How close were the projections to actual activity? What occurred, or did not occur, that caused the difference? Were you overly optimistic or pessimistic?
• Projections may be revised over time to reflect new information and changes in the business environment. Depending on the company, this may be done yearly, quarterly, or even monthly. From a valuation perspective, keep in mind that it is important to understand when the projections were developed. Once a projection is finalized and approved by management, mark the date it was completed. From there, save new versions of the revised projections with updated completion dates.

Other Valuation Considerations

• Valuation Date – The projections and the factors influencing the projections should be known or knowable as of the selected valuation date. Based on valuation standards, the valuation analyst may only consider events and conditions occurring up to and as of the valuation date, not those that take place after the valuation date, if they were not known or knowable at that time. Having projections prepared before the valuation date ensures that knowledge beyond that date was not utilized in their preparation.
• Potential Future Acquisitions – Factoring potential future acquisitions into your projections is challenging from a valuation perspective, particularly since knowing the purchase price necessary to acquire the acquisition-related revenue and profit is typically unknown. Focusing on the company’s existing operations and known future plans as of the valuation date will give you a more accurate estimate of the company’s value.
• Specific Company Risk – It is essential to review your projections in relation to your company’s historical results. Are the projections particularly aggressive, pushing revenue and profit margins higher than what the company has been able to accomplish in the past? How do these growth rates and profit margins compare to others in the industry? More aggressive projections may lead to a higher specific company risk adjustment, which increases the discount rate and in turn lowers the company’s value. Risks and uncertainties in the projections, as well as the company as a whole, will be factored into the discount rate used in the valuation analysis.

While historical financials lay the groundwork for understanding a company’s operations, they may not capture the business’s expected future growth. Well-supported financial projections provide a glimpse into a company’s anticipated future growth and profitability, which may produce a more accurate value of the company. When developing projections, keep in mind that they should be based on reasonable and supportable assumptions and reflect both the opportunities and risks the company faces.