Forecasts vs. projections: What’s the difference?
From the March/April 2017 issue of BCC Advisers Litigation & Valuation Report
aluations are often based on management’s estimates of expected cash flow. Even when a valuation expert or the company’s CPA prepares the estimate, the basis is typically management’s representations about the company’s future plans to handle market opportunities and potential threats. So, it’s important to evaluate whether expected cash flow seems reasonable and appropriate given the purpose of the valuation.
An important distinction
There’s a noteworthy distinction between the terms “forecast” and “projection,” according to AICPA Attestation Standards Section 301, Financial Forecasts and Projections:
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.” [emphasis added]
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 … ?’” [emphasis added]
Valuation professionals generally use forecasts — that is, expected results based on the expected course of action — when appraising private business investments. But projections may sometimes be more appropriate, depending on the nature of the assignment. For example, the date of and reason for preparing the estimate can affect whether forecasts or projections are more relevant, as well as whether certain adjustments to the future earnings are required.
Historical financial statements are a logical starting point for both forecasts and projections. But management can’t necessarily assume that current revenue and expenses will grow at a constant rate commensurate with inflation. That’s unrealistic for many companies today.
Savvy business managers factor emerging threats and market opportunities into their forecasts and projections. They also consider how competitors are performing under the same market conditions. In an evolving or uncertain market, the performance of competitors — especially market leaders — is often more meaningful than historical results.
Effect on value
It’s perfectly acceptable for valuators to rely on an estimate of expected cash flow that’s prepared by the company’s management. But it’s important to understand the type of estimate that was created and gauge whether it appears to be reasonable in today’s marketplace. Small differences in expected cash flow can have a big impact on the value of a business.
For example, suppose management has prepared two estimates of net cash flow over the last year:
1. Equity net cash flow of $10 million based on a projection the company’s owner prepared to apply for financing the construction of a new plant, or
2. Equity net cash flow of $8 million based on a forecast prepared by the company’s CPA in accordance with the AICPA attestation standards.
If a valuator applies a 20% equity capitalization rate to both estimates, the resulting values would be $50 million ($10 million divided by 20%) and $40 million ($8 million divided by 20%). In other words, if the valuator uses the projection rather than the forecast, every $1 of additional net cash flow results in an extra $5 of value at a 20% cap rate.
Know where you stand
A valuation is only as reliable as the assumptions it’s based on. Before using prospective financial statements prepared in-house or by an external CPA, check whether the results represent a forecast (expected results based on the expected course of action) or a projection (expected results based on various hypothetical situations that may or may not occur). It’s common for laypeople to use the terms interchangeably — which can lead to unintended consequences later on.