Speaker Biography Travis Harms, CPA/ABV, CFA

Transcription

1 Speaker Biography Travis Harms, CPA/ABV, CFA Travis W. Harms leads Mercer Capital's Financial Reporting Valuation Group. His practice focuses on providing public and private clients with fair value opinions and related assistance pertaining to goodwill and other intangible assets, stock-based compensation, and illiquid financial assets. Travis is a frequent speaker on fair value accounting topics to audiences of financial executives, auditors, and valuation specialists at professional conferences and other events across the U.S. In addition to his work with clients on financial statement reporting issues, Travis performs valuations used for tax compliance, ESOP compliance, and other purposes for clients in a wide range of industries. Travis is a member of The Appraisal Foundation s working group to address best practices for control premiums, and co-authored the book Business Valuation: An Integrated Theory, Second Edition, with Z. Christopher Mercer, ASA, CFA, ABAR. 1

2 Speaker Biography Ron DiMattia, CPA/ABV, CMA Ron DiMattia founded Corporate Value Partners, Inc. to assist clients with a broad range of valuation, corporate finance and litigation matters. He has significant experience in financial analysis, forecasts/projections, acquisitions, shareholder value measurement and litigation support. He is a sole practitioner and previously was a senior staff member for a regional accounting firm and was a Senior Manager in a Big Four accounting firm s financial advisory services practice. Ron currently serves on the AICPA s ABV Credential Committee and has served on the AICPA s Business Valuations Subcommittee; he was also appointed to the National Accreditation Commission of the AICPA. Additionally, he has served as a member of the AICPA s Governing Council. Ron has been privileged to serve as an instructor for the AICPA ABV Exam Review course as well as introductory valuation courses and the AICPA s National Business Valuation School. 2

3 Learning Objective(s)! Identify several key DCF model inputs! Understand what drives DCF model inputs and how they relate to each other! Learn how to present and interpret DCF model outputs under different scenarios! Evaluate some of the most common biases in assumptions that can undermine cash flow forecasts 3

4 Polling Question! Do you use DCF analysis? Always Most of the time Some of the time Rarely Never 4

5 When to Use DCF or CCF! Use discounted cash flow when: Operations are not in a steady-state Relatively better visibility into the future Relatively more complexity in financial relationships! Use capitalized cash flow when: Operations are in a steady state Relatively poor visibility into the future Financial relationships are relatively straight-forward - Modeling into the future helps capture value implications of management decisions 5

6 Discounted Cash Flows Cash Flow to Invested Capital: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Earnings before Interest & Taxes $1,500 $1,550 $1,602 $1,655 $1,710 $1,767 - Pro Forma Income Taxes (600) (620) (641) (662) (684) (707) = Debt-Free Net Income $900 $930 $961 $993 $1,026 $1,060 + Depreciation & Amortization Capital Expenditures (400) (413) (427) (441) (456) (471) +/- Change in Working Capital (120) (124) (128) (132) (137) (141) = Cash Flow to Total Capital $780 $806 $833 $861 $889 $919 + Terminal Value 10,603 = Total Cash Flows $780 $806 $833 $861 $11,493 Discounting Periods Present Value Factors Present Value of Cash Flows ,521 Indicated Value: Total Capital $9,000 less: Interest-Bearing Debt (3,000) Indicated Value: Equity $6,000 6

7 DCF Nuances! Modeling financial relationships! Integrating assumptions! Sensitivity analyses! Forecasting biases! Over-reliance on models in assessing value 7

8 Modeling Financial Relationships 8

9 What is the first step in developing a financial projection model? 9

10 10

11 Polling Question! Forecast period used: 2-4 years 5 years 6-7 years 7+ years 11

12 Modeling Financial Relationships! Be mindful of modeling financial relationships Unit / volume analysis Store-by-store analysis Fixed and variable costs 12

13 Unit / Volume Analysis! Unit Price and Volume Analysis How much stuff and at what price/margin? In some industries it makes more sense to forecast unit volumes and prepare sensitivity analysis on price. Be careful of product mix! 13

14 Store-by-Store Analysis Year 1 Store 1 Store 2 Store 3 Store 4 Store 5 Total Sales 1,000,000 1,500, ,000 2,000, ,250,000 Cost of goods sold 800,000 1,200, ,000 1,600, ,200,000 Gross profit 200, , , , ,050,000 Operating expense 150, , , , ,000 Operating profit 50,000 50,000 (50,000) 200, ,000 Inventory 270, , , , ,350,000 Fixed assets 250, , , , ,250,000 Other assets 25,000 50,000 15,000 35, ,000 Remember to do store-by-store analysis for retailers. Be careful about allocations from corporate activities 14

15 Fixed Costs! Fixed vs. Variable Costs Is operating leverage real or just a fantasy? Fixed costs often take a step up after a relevant range. Be careful how you forecast fixed costs and margins margins rise as you approach the end of the relevant range, and then fall back after the fixed cost step up 15

16 Polling Question! Can fixed costs take a step down if revenue falls? Always Never It depends 16

17 Margin Matters! The revenue and expense assumptions may be reasonable in isolation, but do they work together? Trends over time Projected margins relative to history Projected margins relative to industry peers Projected margins relative to strategy 17

18 Polling Question! Do you use historical averages to build forecast assumptions? Always Sometimes Never 18

19 Integrating Assumptions 19

20 Integrating Assumptions! Assumptions in a DCF model must be integrated Capital Expenditures & Depreciation Working Capital Other Assets & Liabilities Interest-Bearing Debt & Interest Expense Discounting period EOY vs. mid-year Terminal value (or residual value) assumed growth 20

21 What s Wrong with this Picture? Year 1 Year 2 Year 3 Year 4 Year 5 Sales $5,000,000 $6,000,000 $7,000,000 $8,000,000 $9,000,000 Op g profit 500, , ,000 1,280,000 1,800,000 W/C (100,000) (90,000) (80,000) (70,000) (60,000) Capital Exp. (50,000) (50,000) (50,000) (50,000) (50,000) Depreciation 65,000 65,000 65,000 65,000 65,000 21

22 Terminal Value! Make sure long-term growth estimate makes sense for the client and industry Be careful of biases!! Gordon Growth model! Exit multiple Either is appropriate just be careful how you use it! 22

23 Polling Question! Do you develop terminal values using: Gordon Growth model Exit multiples Combination it depends on the engagement Something else 23

24 Discounted Cash Flows Cash Flow to Invested Capital: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Earnings before Interest & Taxes $1,500 $1,550 $1,602 $1,655 $1,710 $1,767 - Pro Forma Income Taxes (600) (620) (641) (662) (684) (707) = Debt-Free Net Income $900 $930 $961 $993 $1,026 $1,060 + Depreciation & Amortization Capital Expenditures (400) (413) (427) (441) (456) (471) +/- Change in Working Capital (120) (124) (128) (132) (137) (141) = Cash Flow to Total Capital $780 $806 $833 $861 $889 $919 + Terminal Value 10,603 = Total Cash Flows $780 $806 $833 $861 $11,493 Discounting Periods Present Value Factors Present Value of Cash Flows ,521 Indicated Value: Total Capital $9,000 less: Interest-Bearing Debt (3,000) Indicated Value: Equity $6,000 24

25 Discounted Cash Flows Cash Flow to Equity: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Earnings before Interest & Taxes $1,500 $1,550 $1,602 $1,655 $1,710 $1,767 - Interest Expense (300) (310) (320) (331) (342) (353) = Pre-tax Income $1,200 $1,240 $1,281 $1,324 $1,368 $1,414 - Income Taxes (480) (496) (513) (530) (547) (566) = Net Income $720 $744 $769 $794 $821 $848 + Depreciation & Amortization Capital Expenditures (400) (413) (427) (441) (456) (471) +/- Change in Working Capital (120) (124) (128) (132) (137) (141) +/- Change in Interest-Bearing Debt = Cash Flow to Equity $700 $723 $747 $772 $798 $707 + Terminal Value 7,069 = Total Cash Flows $700 $723 $747 $772 $7,867 Discounting Periods Present Value Factors Present Value of Cash Flows ,911 Indicated Value: Equity $6,000 25

26 Polling Question! Do you use: Cash flow to invested capital only Cash flow to equity only Combination it depends 26

27 Sensitivity Analysis 27

28 Sensitivity Analyses! Depends on the client which sensitivities you will focus on! Be mindful of biases when building sensitivity analyses! Common sensitivities: Cost of capital Long-term growth rate Operating profit margin Market prices in commodity-driven industries 28

29 Sensitivity Analysis! Test sensitivity of Market Value of Equity relative to Cost of Equity and Long Term Growth holding all other assumptions constant (dollars in thousands) Growth Cost of Equity 14% 15% 16% 17% 3% 5,957 5,586 5,272 5,002 4% 6,337 5,896 5,528 5,217 5% 6,812 6,276 5,837 5,472 6% 7,422 6,751 6,216 5,780 29

30 Sensitivity Analysis! Test sensitivity of Market Value of Equity relative to Cost of Equity and Operating Margin holding all other assumptions constant (dollars in thousands) Operating Margin Cost of Equity 14% 15% 16% 17% 1% 1,981 1,918 1,865 1,821 2% 6,337 5,896 5,528 5,217 3% 10,694 9,875 9,191 8,613 4% 15,051 13,853 12,854 12,008 30

31 Polling Question! What is most often the critical variable in sensitivity analyses? Sales growth Gross profit margin Operating profit margin Working capital investment Capital expenditures Cost of capital 31

32 Forecasting Biases 32

33 33

34 Forecasting Biases! Common biases Anchoring: over-reliance on a known quantity to estimate an unknown Failure to consider regression to the mean Illusion of understanding and illusion of validity Failure to properly consider trends / over-reliance on averages 34

35 35

36 Forecasting Biases! Common biases Anchoring: over-reliance on a known quantity to estimate an unknown Failure to consider regression to the mean Illusion of understanding and illusion of validity Failure to properly consider trends / over-reliance on averages 36

37 Model Mania 37

38 Over-Reliance on Models in Assessing Value! Spreadsheets can account for only a small portion of economic reality! Valuation specialists are social scientists, not engineers! Think more like a social scientist, and less like an engineer 38

39 Why is the output of the model reasonable? 39

40 40

41 Wrap-Up and Review 41

42 Key Take-Aways! Be aware of your biases! Does the model match the story?! Always make sure your DCF analysis is integrated! Be aware of financial relationships when building forecasts! Check your model with sensitivity analyses! Always remember it is not the model that produces the estimate of value. Informed judgment and experience are crucial 42

43 Digging Deeper Exploring the Nuances of Discounted Cash Flow Analysis Travis W. Harms, CPA/ABV, CFA Mercer Capital Ronald D. DiMattia, CPA/ABV, CMA Corporate Value Partners, Inc