In the valuation process, cash flow projections are of crucial importance. These in turn depend on estimates for things like market growth or expected market share. When working on projections, people will often make assumptions that are no better than hunches. For Kevin Kaiser that won’t do. Kaiser, who advocates a more rigorous approach, teaches the Advanced Valuation program at the Amsterdam Institute of Finance.
‘Everything’s hard to value’, Kaiser posits. ‘For example, valuing a building may seem easy, but that’s misleading because it depends on what you’re going to do with it. Are you going to rent it out, resell it, destroy it and build a new building? Different people do different things. The value of anything depends on who’s going to own it, and manage it.’
When it is clear who will be determining the future of a business or asset, the next step is to build the cash flow projections. This consists of three phases, Kaiser explains. The first is about studying results from the past. Next comes the forecast for cash flows in the near future. Typically a five to fifteen year forecast period will do. The third step is about modelling the cash flows beyond this period.
The past can offer valuable insight about a business’ potential. Information about revenue development and margins can form a solid basis for scenarios. However, a dangerous pitfall is that people will overinterpret the significance of the data, warns Kaiser.
‘You’re only seeing the one thing that happened. You’re not seeing the infinite number of other things that could have happened. So you have a really misrepresentative sample. This means you need to interpret the data very carefully and thoughtfully. It can sometimes be a very poor guide for what’s actually expected to happen.’
When working on projections it’s important to realize this is about formulating an expectation and not about predicting the future. ‘We know that in reality, the world will either be better or worse, but that’s not going to bother us because we’re not trying to guess what’s going to happen. We’re just trying to understand what is expected.’
Because of the uncertainty of what the future holds, when building a valuation model, people should be able to explain the reasoning behind each and every datapoint they’re putting into it. ‘We’re certain that every number you’ll put in there will be wrong, that’s obvious. So the relevant question is why did you choose the number that you put in there? Your answer could be that you took the average of the industry for the last five years, or that you called your mom and she told you what her friends told her. That’s all fine. The only answer I won’t accept is ‘I assumed it’.
Kaiser wants insight into the thinking that lead to a certain estimate. ‘Humans don’t have the ability to assume. When humans come up with numbers, these are always based on something. Everything we do is based on observation and calculation. Some of it is accessible to us, it’s at the conscious level, some of it is not accessible, it’s at the unconscious level, some of it is instinct. But something happened that produced a number and I want to know what the process was, and what data was used, what analysis someone did.’
Only then is it possible to discuss and debate the input and ultimately improve the forecasting. ‘Say, for example, you took the average, and I chose the trend. We can then discuss which one of those makes more sense. Or say you used data from The Netherlands, while I used data from Canada. We could incorporate those two datasets and learn. However, we can only have a conversation if I know what data you used and what analysis you did.’
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