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Speaker Biography Travis Harms, CPA/ABV, CFA Travis W. Harms leads Mercer Capital's Financial Reporting Valuation Group. His practice focuses on providing public and private clients with fair value opinions and related assistance pertaining to goodwill and other intangible assets, stock-based compensation, and illiquid financial assets.

Travis is a frequent speaker on fair value accounting topics to audiences of financial executives, auditors, and valuation specialists at professional conferences and other events across the U.S.

In addition to his work with clients on financial statement reporting issues, Travis performs valuations used for tax compliance, ESOP compliance, and other purposes for clients in a wide range of industries.

Travis is a member of The Appraisal Foundation’s working group to address best practices for control premiums, and co-authored the book Business Valuation: An Integrated Theory, Second Edition, with Z. Christopher Mercer, ASA, CFA, ABAR.

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Speaker Biography Ron DiMattia, CPA/ABV, CMA Ron DiMattia founded Corporate Value Partners, Inc. to assist clients with a broad range of valuation, corporate finance and litigation matters. He has significant experience in financial analysis, forecasts/projections, acquisitions, shareholder value measurement and litigation support. He is a sole practitioner and previously was a senior staff member for a regional accounting firm and was a Senior Manager in a “Big Four” accounting firm’s financial advisory services practice.

Ron currently serves on the AICPA’s ABV Credential Committee and has served on the AICPA’s Business Valuations Subcommittee; he was also appointed to the National Accreditation Commission of the AICPA. Additionally, he has served as a member of the AICPA’s Governing Council. Ron has been privileged to serve as an instructor for the AICPA ABV Exam Review course as well as introductory valuation courses and the AICPA’s National Business Valuation School.

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Learning Objective(s)

! Identify several “key” DCF model inputs

! Understand what drives DCF model inputs and how they relate to each other

! Learn how to present and interpret DCF model outputs under different scenarios

! Evaluate some of the most common biases in assumptions that can undermine cash flow forecasts

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Polling Question

! Do you use DCF analysis?

•  Always

•  Most of the time

•  Some of the time

•  Rarely

•  Never

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! Use discounted cash flow when: •  Operations are not in a

steady-state

•  Relatively better visibility into the future

•  Relatively more complexity in financial relationships

- Modeling into the future helps capture value implications of management decisions

! Use capitalized cash flow when: •  Operations are in a steady

state

•  Relatively poor visibility into the future

•  Financial relationships are relatively straight-forward

When to Use DCF or CCF

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Discounted Cash Flows

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6Earnings before Interest & Taxes $1,500 $1,550 $1,602 $1,655 $1,710 $1,767 - Pro Forma Income Taxes (600) (620) (641) (662) (684) (707)= Debt-Free Net Income $900 $930 $961 $993 $1,026 $1,060+ Depreciation & Amortization 400 413 427 441 456 471 - Capital Expenditures (400) (413) (427) (441) (456) (471)+/- Change in Working Capital (120) (124) (128) (132) (137) (141)= Cash Flow to Total Capital $780 $806 $833 $861 $889 $919+ Terminal Value 10,603= Total Cash Flows $780 $806 $833 $861 $11,493 Discounting Periods 1.0 2.0 3.0 4.0 5.0 Present Value Factors 0.8929 0.7972 0.7118 0.6355 0.5674Present Value of Cash Flows 696 643 593 547 6,521

Indicated Value: Total Capital $9,000less: Interest-Bearing Debt (3,000)Indicated Value: Equity $6,000

Cash Flow to Invested Capital:

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DCF Nuances

! Modeling financial relationships

! Integrating assumptions

! Sensitivity analyses

! Forecasting biases

! Over-reliance on models in assessing value

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Modeling Financial Relationships

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What is the first step in developing a financial projection model?

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Polling Question

! Forecast period used:

•  2-4 years

•  5 years

•  6-7 years

•  7+ years

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Modeling Financial Relationships

! Be mindful of modeling financial relationships

•  Unit / volume analysis

•  Store-by-store analysis

•  Fixed and variable costs

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Unit / Volume Analysis

! Unit Price and Volume Analysis •  How much “stuff” and at what price/margin?

In some industries it makes more sense to forecast unit volumes and prepare sensitivity analysis on price. Be careful of product mix!

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Store-by-Store Analysis

Year 1 Store 1

Store 2

Store 3

Store 4

Store 5

Total

Sales 1,000,000 1,500,000 750,000 2,000,000 -0- 5,250,000 Cost of goods sold 800,000 1,200,000 600,000 1,600,000 -0- 4,200,000 Gross profit 200,000 300,000 150,000 400,000 -0- 1,050,000 Operating expense 150,000 250,000 200,000 200,000 -0- 800,000 Operating profit 50,000 50,000 (50,000) 200,000 -0- 250,000

Inventory 270,000 480,000 200,000 400,000 -0- 1,350,000 Fixed assets 250,000 400,000 200,000 400,000 -0- 1,250,000 Other assets 25,000 50,000 15,000 35,000 -0- 125,000

Remember to do store-by-store analysis for retailers. Be careful about allocations from corporate activities

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Fixed Costs ! Fixed vs. Variable Costs

•  Is operating leverage real or just a fantasy?

Fixed costs often take a “step” up after a “relevant range.” Be careful how you forecast fixed costs and margins – margins rise as you approach the end of the relevant range, and then fall back after the fixed cost “step” up

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Polling Question

! Can fixed costs take a “step” down if revenue falls?

•  Always

•  Never

•  It depends

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Margin Matters

! The revenue and expense assumptions may be reasonable in isolation, but do they work together?

•  Trends over time

•  Projected margins relative to history

•  Projected margins relative to industry peers

•  Projected margins relative to strategy

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Polling Question

! Do you use historical averages to build forecast assumptions?

•  Always

•  Sometimes

•  Never

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Integrating Assumptions

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Integrating Assumptions

! Assumptions in a DCF model must be integrated •  Capital Expenditures & Depreciation

•  Working Capital

•  Other Assets & Liabilities

•  Interest-Bearing Debt & Interest Expense

•  Discounting period – EOY vs. mid-year

•  Terminal value (or residual value) – assumed growth

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What’s Wrong with this Picture?

Year 1

Year 2

Year 3

Year 4

Year 5

Sales $5,000,000 $6,000,000 $7,000,000 $8,000,000 $9,000,000

Op’g profit 500,000 720,000 980,000 1,280,000 1,800,000

W/C (100,000) (90,000) (80,000) (70,000) (60,000)

Capital Exp. (50,000) (50,000) (50,000) (50,000) (50,000)

Depreciation 65,000 65,000 65,000 65,000 65,000

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Terminal Value

! Make sure long-term growth estimate makes sense for the client and industry •  Be careful of biases!

! Gordon Growth model

! Exit multiple •  Either is appropriate – just be careful how you use it!

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Polling Question

! Do you develop terminal values using:

•  Gordon Growth model

•  Exit multiples

•  Combination – it depends on the engagement

•  Something else

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Discounted Cash Flows

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6Earnings before Interest & Taxes $1,500 $1,550 $1,602 $1,655 $1,710 $1,767 - Pro Forma Income Taxes (600) (620) (641) (662) (684) (707)= Debt-Free Net Income $900 $930 $961 $993 $1,026 $1,060+ Depreciation & Amortization 400 413 427 441 456 471 - Capital Expenditures (400) (413) (427) (441) (456) (471)+/- Change in Working Capital (120) (124) (128) (132) (137) (141)= Cash Flow to Total Capital $780 $806 $833 $861 $889 $919+ Terminal Value 10,603= Total Cash Flows $780 $806 $833 $861 $11,493 Discounting Periods 1.0 2.0 3.0 4.0 5.0 Present Value Factors 0.8929 0.7972 0.7118 0.6355 0.5674Present Value of Cash Flows 696 643 593 547 6,521

Indicated Value: Total Capital $9,000less: Interest-Bearing Debt (3,000)Indicated Value: Equity $6,000

Cash Flow to Invested Capital:

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Discounted Cash Flows

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6Earnings before Interest & Taxes $1,500 $1,550 $1,602 $1,655 $1,710 $1,767 - Interest Expense (300) (310) (320) (331) (342) (353)= Pre-tax Income $1,200 $1,240 $1,281 $1,324 $1,368 $1,414 - Income Taxes (480) (496) (513) (530) (547) (566)= Net Income $720 $744 $769 $794 $821 $848+ Depreciation & Amortization 400 413 427 441 456 471 - Capital Expenditures (400) (413) (427) (441) (456) (471)+/- Change in Working Capital (120) (124) (128) (132) (137) (141)+/- Change in Interest-Bearing Debt 100 103 107 110 114 0= Cash Flow to Equity $700 $723 $747 $772 $798 $707+ Terminal Value 7,069= Total Cash Flows $700 $723 $747 $772 $7,867 Discounting Periods 1.0 2.0 3.0 4.0 5.0 Present Value Factors 0.8696 0.7561 0.6575 0.5718 0.4972Present Value of Cash Flows 609 547 491 442 3,911

Indicated Value: Equity $6,000

Cash Flow to Equity:

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Polling Question

! Do you use:

•  Cash flow to invested capital only

•  Cash flow to equity only

•  Combination – it depends

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Sensitivity Analysis

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Sensitivity Analyses

! Depends on the client which sensitivities you will focus on

! Be mindful of biases when building sensitivity analyses

! Common sensitivities: •  Cost of capital

•  Long-term growth rate

•  Operating profit margin

•  Market prices in commodity-driven industries

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Sensitivity Analysis

! Test sensitivity of Market Value of Equity relative to Cost of Equity and Long Term Growth holding all other assumptions constant (dollars in thousands)

Growth Cost of Equity

14% 15% 16% 17%

3% 5,957 5,586 5,272 5,002

4% 6,337 5,896 5,528 5,217

5% 6,812 6,276 5,837 5,472

6% 7,422 6,751 6,216 5,780

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Sensitivity Analysis

! Test sensitivity of Market Value of Equity relative to Cost of Equity and Operating Margin holding all other assumptions constant (dollars in thousands)

Operating Margin Cost of Equity

14% 15% 16% 17%

1% 1,981 1,918 1,865 1,821

2% 6,337 5,896 5,528 5,217

3% 10,694 9,875 9,191 8,613

4% 15,051 13,853 12,854 12,008

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Polling Question

! What is most often the critical variable in sensitivity analyses?

•  Sales growth

•  Gross profit margin

•  Operating profit margin

•  Working capital investment

•  Capital expenditures

•  Cost of capital

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Forecasting Biases

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Forecasting Biases

! Common biases

•  Anchoring: over-reliance on a known quantity to estimate an unknown

•  Failure to consider regression to the mean

•  Illusion of understanding and illusion of validity

•  Failure to properly consider trends / over-reliance on averages

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Forecasting Biases

! Common biases

•  Anchoring: over-reliance on a known quantity to estimate an unknown

•  Failure to consider regression to the mean

•  Illusion of understanding and illusion of validity

•  Failure to properly consider trends / over-reliance on averages

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Model Mania

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Over-Reliance on Models in Assessing Value

! Spreadsheets can account for only a small portion of economic reality

! Valuation specialists are social scientists, not engineers

! Think more like a social scientist, and less like an engineer

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Why is the output of the model reasonable?

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Wrap-Up and Review

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Key Take-Aways

! Be aware of your biases ! Does the model match the story? ! Always make sure your DCF analysis is integrated ! Be aware of financial relationships when building

forecasts ! Check your model with sensitivity analyses ! Always remember – it is not the model that produces

the estimate of value. Informed judgment and experience are crucial

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Digging Deeper Exploring the Nuances of Discounted Cash Flow Analysis

Travis W. Harms, CPA/ABV, CFA Mercer Capital

harmst@mercercapital.com 901.685.2120

Ronald D. DiMattia, CPA/ABV, CMA Corporate Value Partners, Inc.

ron@corporatevaluepartners.com 216.741.1330