5 principles for a practical valuation

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A practical valuation analysis is the goal of every valuation engagement. If a valuation analysis is impractical and cannot be understood by its intended audience, the analysis is rendered useless. I adhere to the following five principles to ensure a practical valuation analysis. These five principles apply to any level of valuation work, from the most detailed valuation report all the way down to a simple work-up and discussion.

  1. Avoid an emphasis on history

The past is what we know. We can feel comfortable with the past. We have it signed, sealed, and archived via filed tax returns. And the past is important, but the past is not what determines the value of a company. The future is what determines the value of a company. Don’t dwell on the risks that affected the company last year, spend time predicting the risks that will affect the company in years to come. For a practical valuation, don’t revel in the successes of the past, but determine how and when to expect future successes.

  1. Focus on the forecast

The foundation of any good valuation lies in the forecast of cash flows. The closer we can get to predicting the exact cash flow to be expected from a company in the years to come, the better our estimate of value will be. A good forecast entails much more than an average of the last three years results. A practical valuation requires a practical forecast. And a practical forecast requires time and communication between myself and company management.

  1. Avoid sweeping discounts

If we (company management, with my assistance) invest the time in generating a solid, defensible forecast of cash flow, the last thing we want to do is jeopardize it with an indefensible discount rate. A discount rate is used to account for the risk of the investment over time. However, discount rates are inherently difficult to defend. We don’t want to rely any more on the discount rate than we have to. A practical valuation factors marketability, size, and industry issues into the company forecast rather than tacking on risk premiums to the discount rate.

  1. Predict opposing arguments

Look at the company through the eyes of a potential buyer. What issues might concern a potential buyer? What ideas might a potential buyer have? A practical valuation does not avoid or gloss over problem areas, instead a practical valuation dwells on problem areas until they have been adequately incorporated and explained.

  1. Be realistic

A practical valuation must be realistic. An overly optimistic or overly conservative analysis will come across as biased. Detected bias raises red flags. For example, an unrealistic expected revenue stream for the company (high or low) might leave the intended audience wondering if the entire analysis is tainted. Every step of the way, check back in. Does this discount rate make sense? Is this forecast defensible? Is this analysis realistic? If the answer is yes, we are on our way to a practical valuation.