The Dangers of Using Loan Projections in Business Valuation

Unrealistic Projections Undermine Valuation Expert’s Credibility

In Magarik, shareholders in a plumbing fixtures company disagreed on the fair value of the company. The shareholder’s valuation expert, relying heavily on the company’s loan application projections, arrived at a significantly higher valuation than the company’s expert. The court, however, found the shareholder’s expert’s analysis to be flawed.

The court criticized the shareholder’s expert for relying on “unrealistic and optimistic” projections from the loan application. These projections failed to adequately account for the competitive landscape and the company’s history of negative cash flow. Furthermore, the expert’s analysis included the value of a brand owned by another entity, a factor not directly attributable to the subject company.

The appellate court upheld the trial court’s decision, emphasizing the importance of credible and realistic assumptions in business valuation.

The Dangers of Relying on Loan Application Projections

Loan applications typically present an optimistic view of a company’s future financial performance, often emphasizing growth potential and downplaying risks. These projections are intended to persuade lenders, not to provide an unbiased assessment of fair market value.  In fact, many lending underwriters will inherently discount the financial information presented to reflect their belief the financials are likely overstated.

Valuation experts must exercise professional skepticism when reviewing management-provided projections especially when they are sourced from a loan application. It’s crucial to:

• Independently verify the assumptions underlying the projections: This may involve conducting market research, analyzing industry trends, and assessing the competitive landscape.
• Consider the source and purpose of the projections: Projections prepared for a loan application may not accurately reflect the company’s true economic potential.
• Adjust projections as necessary: If the expert believes the projections are overly optimistic, adjustments should be made to reflect a more realistic assessment of future performance.

Ensuring a Defensible Valuation

A robust business valuation requires a thorough and objective analysis. Key factors contributing to a defensible valuation include:

• Engaging experienced and credentialed valuation professionals: Selecting qualified experts with in-depth knowledge of relevant industries and valuation methodologies is essential.
• Conducting thorough due diligence: This involves a comprehensive review of the company’s financial records, operations, and market position.
• Applying sound valuation methodologies: Utilizing appropriate valuation methods and ensuring the consistent application of these methods throughout the analysis.

By adhering to these principles, businesses and their advisors can increase the likelihood of arriving at a credible and defensible valuation. Sound and objective analysis in business valuation is crucial. By understanding the potential pitfalls of relying on biased information, businesses can make more informed decisions and mitigate risks associated with valuation disputes.

Disclaimer: This article provides general information and should not be considered professional financial or tax advice. Please consult with a qualified CPA or financial advisor for guidance specific to your individual business needs.