A Tale of Two Appraisers – Or Two Companies

Every Single-Period Income Capitalization Entails an Implied Forecast

It is a fact that for every use of the single period income capitalization method, where a single assumption about expected earnings is made as a representative of “expected” earnings, there is an implied forecast of earnings and an implied use of the discounted cash flow method. This Valuation Video provides two looks – and two forecasts – for a company that might have been prepared by two different appraisers. The question addressed in this Valuation Video is whether the “forecasts” used in single-period income capitalizations are reasonable and the best representation of near-term expected cash flows and their future growth. I think the perspectives offered will be worth your time to listen to the video or to read the transcript.

It’s a fact — every time a business appraiser or market participant uses a single period income capitalization method to determine a value indication, there is an implicit use of the discounted cash flow method. Chris Mercer here at Mercer Capital’s headquarters in Memphis. I’m back up in Memphis from Port Orange where I did the last one. I am glad to be here, and I want to talk to you about a tale of two appraisers — a tale of two companies — or perhaps, which company are we appraising?

So let’s talk about an example company and show what can happen when we employ the single period income capitalization method and we look at the implied discounted cash flows. First though, remember value is expected cash flow — that is, expected cash flow — capitalized by a discount rate less the expected growth rate in value. So that’s our value. Assume that two appraisers agree that the appropriate valuation multiple of EBITDA is 6x, and that is implicit in this weighted average cost of capital that they have each employed. So, let’s see what happens.

Here’s the company: $2 million dollars in 2014 and it just it went down to $1.7 (million), or 15%. The next year — up 33 percent to $2.6 million — and 2016, down 32% to $1.5 million in 2017 and back up 62% to $2.5 million in 2018. Management’s expectation for EBITDA for the coming year is $2.8 million for 2019. So appraiser one looks at this company and says the appropriate valuation method to determine capitalizable EBITDA is to take a weighted average — one on each year for five years and 0 on the expected EBITDA for 2019. That yields a weighted average EBITDA of $2 million dollars. Okay. So $2 million dollars is the historical trend line — that this appraiser is utilizing and $2 million dollars is the base that will be capitalized. The next appraiser says, “No, wait a minute. I think that management has something going here and the appropriate weights are three on the forecast, two on the current year, and one on 2017 — that weighted average is $2.5 million. So there’s a big difference between $2 million and $2.5 million!

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Now we can look at the implied forecasts that each of these looks at. The trend line implied by the first appraiser is $2 million along this way — and now $2 million dollars growing at three or four percent —whatever is implied by or used in the discount rate. The other appraiser says no the trend line is really along this line to the $2.8 million dollars, that is, at the expected results in 2019. The first appraiser has this trend line and this forecast coming from a base of $2 million dollars. So it’s growing from here. The second appraiser has this trend line, and it’s growing from $2.5 million dollars at the growth rate of G — could be the growing from $2.8 million if one absolutely believes management’s forecast. Well, which is correct? The trend line of 1, 3, and 5 and a forecast growth of 3%, or 2, 4 and 6, and a forecast growth of 3 or 4%. The answer lies in what happened in number one in 2015 and what happened in number 3 in 2017? And then, number three, how much do we believe management’s forecast for the future for 2019 and beyond?

One appraiser believed that management incurred some issues in 2015 that were fixed and then again some other issues in 2017 that were fixed and realizes that capacity was added in 2018 and will be added again in 2019. That’s the forecast with three weighted on the forecast, two on the current year, and one on the preceding year — to give weight to the poor performance before. So which one is correct? Well, I can’t answer that question today. But what I can say is that fair market value is that determined at the intersection of negotiations between hypothetical willing sellers and hypothetical willing buyers. If the forecast is appropriate for the first appraiser, and expected earnings for 2019 are really $2 million as opposed to $2.8 million — then that hypothetical willing buyer would value the company it $12 million dollars. But what if the seller believes, for example, that the management’s forecast is most appropriate, that management forecast of 6x expected EBITDA would be $16.8 million.

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Where is the answer? It is somewhere in between — but in all likelihood, if it’s believable that management has addressed the issues in 1 and 3 and that the forecast is based upon enhanced capacity, as well, then management’s forecast is a good one. Then the answer may well be the 3. 2. 1. weights, which yielded about a $2.5 million dollar EBITDA. So that would have been about a $15 million dollar valuation.

The point is this when we use the single period income capitalization method we are implicitly applying a discounted cash flow method. The question really is — Is that discounted cash flow — that forecast that we’re using — realistic? You see this wedge here between the two weighted averages is $500 thousand dollars a year at the multiple of 6x. That’s a $3 million dollar difference that will never be caught up. If the company is doing better, it will never be caught up in terms of value. So once again every time a business appraiser or market participant uses a single period income capitalization method to determine a value indication, there is an implicit discounted cash flow forecast. My question to you is, when you do this, is your forecast the correct one? Is it one, the lower one? Is it two, the higher one, or is it indeed something else? That’s a matter of appraiser judgment. I’ll leave that to you.

This is Chris Mercer. I wish you the best until the next Valuation Video.

Good day.

Please note: I reserve the right to delete comments that are offensive or off-topic.

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2 thoughts on “A Tale of Two Appraisers – Or Two Companies

  1. I appreciate your comments and insight. What you are really saying is with all the analytical techniques we have, business valuation is indeed and art as well as technical. Standing back after doing due diligence exploring the economy, industry, and firm with feedback from management, the appraiser still has to develop their analysis and defend why a particular approach is taken. You provide an excellent example of how seemingly simple assumptions can make a material difference. It is important to develop the facts to a point where the appraiser can defend a particular approach. Well done.