In Business Valuation: An Integrated Theory Third Edition (Mercer and Harms), we discuss the organizing principles of the “world of value.”  The Principle of Expectations is the first such principle.

Definition.  The value of a business is the present value of all expected future cash flows and their growth, discounted to the present at a discount rate reflective of the risks associated with the receipt of those cash flows.

Every business appraisal has a forecast of expected future earnings, either explicit or implied.  We discussed this concept in a recent post.  It should go without saying, but these forecasts should reflect reasonable expectations.  However, sometimes, the forecasts in business appraisal reports reflect unrealistic expectations.

One of the most frequent problems seen in appraisal reports today is the use of projected earnings that bear little or no resemblance to those of the past.  These projections often lack any explanation of how the rose-colored glasses through which they view a business reflect realistic expectations for the future of a business.  The projections phenomenon is so common that it has been given a name: hockey-stick projections.

In a deposition a number of years ago, I was asked how a bank with currently low earnings could possibly meet the projections found in bank management’s own current capital plan for the next five years.  The deposing attorney accused me of unrealistically relying on the capital plan, which was prepared by his client for regulatory review in the normal course of business.  How could any bank possibly achieve a hockey-stick set of projections. (Parenthetically, this was a statutory fair value matter in which the bank had squeezed out my client. The bank wanted a low result, of course; however, my client, a large minority shareholder, wanted at least a reasonable result).

I referred the attorney to the exhibit in our report that compared the previous five years’ performance with the earnings and returns of the capital plan.  There, it was clear that the projected returns (on assets and equity) were within the levels achieved by the bank in the previous few years, and below the current level of the bank’s peer group.  Value today is a function of expectations for future performance – and the expectations used were in line with past performance, management’s stated plans, management’s business plan, and the performance of similar banks.

Valuation analysts should remember that every going-concern business appraisal reflects, either implicitly or explicitly, a projection of expected future performance.  If the expectations imbedded in the valuation are not realistic, the resulting conclusions will be flawed.

Until next time, be well.

— Chris

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