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Potential, Projections … and poppycock! The owners of most of the businesses we are asked to sell or value assure us that their business has potential. Very often this is so - but most buyers are unwilling to pay for that possibility as it is their time, capital, and effort that will access the potential.Of course, there are occasions where there has been investment ahead of income (e.g. purchase of a new production machine with a certain increase in revenue and profitability). This should rightly be recognised in the price or value. Where we do have concerns is when the owner or advisor produces forecasts or projections which hugely exceed trends and historic performance. If we are presented with a "hockey stick" forecast, there be dragons! Predicting the future for any business is difficult. Witness the number of public company profit forecasts downgraded in recent weeks despite having in-house accountants, audited financials, and extensive market knowledge. How much more difficult is it for SME where there is generally a higher level of personal goodwill, unaudited accounts, and greater staffing pressures? Our scepticism about forecasts has been accelerated by reading "The Black Swan" by Nicholas Nassim Taleb. His "black swans" are happenings which lie outside the realm of regular expectations, have an extreme impact, and have retrospective (tho' not prospective) predictability. Recent examples includes 9/11, the development of the internet, the ubiquity of Google, and the rise and sale of TradeMe. Taleb's book is a fun read - he debunks Portfolio theory, criticises the "efficient market" supposition, and says "the problem with experts is that they do not know what they do not know". Buyers of businesses are buying the future cash flow of the company. Valuation should be forward looking. But profit and cash flow forecasts should always be tested for reasonableness. |
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