This series of articles will address a critical practice area – the proper development and use of prospective financial information (PFI) for valuation purposes. A comprehensive example will be introduced that focuses on the valuation of a business enterprise; however, the concepts can be applied to the valuation of any asset, liability or other subject of interest. Ultimately, this topic is about numerators (estimated cash flows) and denominators (discount rates).
In this first installment, we will carefully define a number of terms that appear in the accounting and valuation literature. Subsequent articles will:
- Describe generic types of PFI
- Review the implications of the new MPF guidance
- Discuss development of discount rates consistent with identified risk profile
Financial Reporting Areas where PFI applies
We begin with some definitions from an American Institute of Certified Public Accountants (AICPA) practice aid (now AT Section 301) that originally was targeted at professionals who were examining, compiling or applying agreed-upon procedures to prospective financial statements prepared by other parties (usually a client) but generically referred to as a “responsible party:”
Prospective financial statements: Either financial forecasts or financial projections including the summaries of significant assumptions and accounting policies. Although prospective financial statements may cover a period that has partially expired, statements for periods that have completely expired are not considered to be prospective financial statements. Pro forma financial statements and partial presentations are not considered to be prospective financial statements.
Financial forecast: Prospective financial statements that present, to the best of the responsible party's knowledge and belief, an entity's expected financial position, results of operations and cash flows. A financial forecast is based on the responsible party's assumptions reflecting the conditions it expects to exist and the course of action it expects to take. A financial forecast may be expressed in specific monetary amounts as a single point estimate of forecasted results or as a range, where the responsible party selects key assumptions to form a range within which it reasonably expects, to the best of its knowledge and belief, the item or items subject to the assumptions to actually fall.
When a forecast contains a range, the range is not selected in a biased or misleading manner, for example, a range in which one end is significantly less expected than the other.
Financial projection: Prospective financial statements that present, to the best of the responsible party's knowledge and belief, given one or more hypothetical assumptions, an entity's expected financial position, results of operations and cash flows. A financial projection is sometimes prepared to present one or more hypothetical courses of action for evaluation, as in response to a question such as, "What would happen if… ?“ A financial projection is based on the responsible party's assumptions reflecting conditions it expects would exist and the course of action it expects would be taken, given one or more hypothetical assumptions. A projection, like a forecast, may contain a range.
Hypothetical assumption: An assumption used in a financial projection to present a condition or course of action that is not necessarily expected to occur, but is consistent with the purpose of the projection.
Key factors: The significant matters on which an entity's future results are expected to depend. Such factors are basic to the entity's operations and thus encompass matters that affect, among other things, the entity's sales, production, service and financing activities. Key factors serve as a foundation for prospective financial statements and are the bases for the assumptions.
A critical distinction that is worthy of note: Historically, the valuation profession has not exercised much precision in how it defines various types of PFI. The terms forecast, projection, budget, and even pro forma are often used interchangeably. In particular, the term pro forma is often used incorrectly; technically, pro forma refers to historical information that has been restated for some purpose, NOT to PFI. Although, this imprecision does not usually lead to misunderstandings or errors, we recommend that practitioners migrate towards the proper use of these terms, or alternatively, to substitute the term “PFI” which, although not as descriptive, is rarely incorrect.
Techniques Impacted by PFI
Our next set of definitions originally appeared in FASC Statement #7 (CON7), and then, after further clarification, were elevated to primary GAAP via FASB 157, Appendix B (now ASC 820).
The discount rate adjustment technique uses a single set of cash flows from the range of possible estimated amounts, whether contractual or promised (as is the case for a bond) or most likely cash flows. In all cases, those cash flows are conditional upon the occurrence of specified events (e.g., contractual or promised cash flows for a bond are conditional on the event of no default by the debtor). The discount rate used in the discount rate adjustment technique is derived from observed rates of return for comparable assets or liabilities that are traded in the market. Accordingly, the contractual, promised, or most likely cash flows are discounted at a rate that corresponds to an observed market rate associated with such conditional cash flows (market rate of return).
The expected present value technique uses as a starting point a set of cash flows that, in theory, represents the probability-weighted average of all possible cash flows (expected cash flows). The resulting estimate is identical to expected value, which, in statistical terms, is the weighted average of a discrete random variable’s possible values where the respective probabilities are used as weights. Because all possible cash flows are probability weighted, the resulting expected cash flow is not conditional upon the occurrence of any specified event (as are the cash flows used in the discount rate adjustment technique).
Method 1 of the expected present value technique adjusts the expected cash flows (i.e., the numerator) for the systematic (market) risk by subtracting a cash risk premium (risk-adjusted expected cash flows). These risk-adjusted expected cash flows represent a certainty-equivalent cash flow, which is discounted at a risk-free interest rate. A certainty-equivalent cash flow refers to an expected cash flow (as defined), adjusted for risk such that one is indifferent to trading a certain cash flow for an expected cash flow.
In contrast, Method 2 of the expected present value technique adjusts for systematic (market) risk by adding a risk premium to the risk-free interest rate (i.e., the denominator). Accordingly, the expected cash flows are discounted at a rate that corresponds to an expected rate associated with probability-weighted cash flows (expected rate of return). Models used for pricing risky assets, such as the Capital Asset Pricing Model, can be used to estimate the expected rate of return. Because the discount rate used in the discount rate adjustment technique is a rate of return relating to conditional cash flows, it likely will be higher than the discount rate used in Method 2 of the expected present value technique, which is an expected rate of return relating to expected or probability-weighted cash flows.
We highlight this last section, because it concisely states a critical concept that we will return to in a future article – how to match the risk of the cash flows to the proper discount rate. If, for example, one is using a “success-based PFI” in which one or more uncertain, conditional events are assumed to be resolved favorably, then the discount rate must include a premium, such as a specific company risk premium (SCRP) or additional risk premium (ARP) to properly adjust for this assumption. If, on the other hand, the PFI is based on multiple scenarios that include best-case, most likely case, low case, etc. that have been properly weighted based on their probabilities of occurrence, these weighted cash flow estimates have already been partially adjusted for risk, potentially reducing the magnitude of an SCRP or ARP adjustment to the discount rate.
It is our hope that this series of articles, which will address the proper development and use of prospective financial information (PFI) for valuation purposes, will be useful to you in your endeavors. Please contact Valuation@alvarezandmarsal.com to learn more.