3.22: Pro forma cashflow statements
A major principle in developing a fair market value conclusion is that valuation is forward looking. This is somewhat intuitive if you put yourself in the shoes of a prospective buyer. The buyer is primarily interested in the prospects for the business and while the historical results for the business may help to project its future, the past is only a partial guide to the future.
Pro forma cashflow statements represent the CBV’s best estimate of the business’s annual prospective cashflows under the conditions prevailing at the valuation date.
In my view, when valuing a business using the capitalized cashflow method*, there is no credible substitute to developing a pro forma cashflow statement on a line by line basis. Pro forma cashflow statements represent the business valuator’s best estimate of the business’s annual future cashflows under the conditions prevailing at the valuation date. In developing pro forma cashflow statements, I look at historical income statements and analyse the line items for percentage of revenue and year on year growth rates. I consider the environment that the business operates in, at the valuation date, primarily from the perspective of economic, industry, political, and company specific issues, and estimate the impact on each line in the business’s income statement.
I recognize that results may be in a range. I do not look beyond the foreseeable future and usually confine my outlook to one year. I assume that there are no changes to the business, other than those that the current ownership creates. I “normalize” some items for e.g. salaries, where owner-managers have been taking a salary that is different to what they would pay an independent person. I allow for sustaining capital asset replacements. I judiciously take account of the views of current owner-managers. I do not build in any advantages that may result from a change of ownership.
The result is a prospective cashflow statement that best represents my view of what the business could achieve in the currently foreseeable environment under competent management independent of the current owner.
* The capitalized cashflow method is suitable for companies with reasonably stable operating results. When valuing a high growth company, the discounted cashflow method (which looks forward several years) is likely more suitable.
Contact MVI if you need help understanding how the pro forma statements are derived.