This page discusses the use of static forecasting models.
As a matter of fairness the buyer of a firm with goodwill should share profits with the seller only to the extent that the seller’s customers agree to keep patronizing the firm after the equity transfer. Also the buyer should share profits only as long as the customers, clients or patients (CCPs) remain CCPs. Finally, buyer should not have to share profits from future patronizations forever.
But how you might want to know can we ever forecast with any precision exactly how many CCPs will transfer, exactly how long they will remain CCPs, and exactly how much future profits or discretionary earnings they will generate in the future. The truthful answer is that if we demand precise exact numbers for these critical variables, then we cannot accomplish this. However, if we are realistic we can recognize that for each of these key variables there are ranges of plausible values and that we can utilizing dynamic modeling to give buyers and sellers forecasts of probabilistic outcomes that they will find useful in negotiating a fair equity price.
Rules of thumb and the income method as currently applied by most credentialed appraisers utilize static methods of forecasting the future profitability of firms subject to appraisal. Formulas and capitalization or earnings methods (a variant of the income method) simply assume that the most recent financial performance of the firm will go on forever.
Another variant of the income method will use at most a five year forecast and then assume that all subsequent years will mimic the fifth year with a constant never ending growth rate in profits. All these static models are wildly unrealistic and there application does a grave disservice to buyers and sellers of closely held firms. The more useful and realistic approach is to utilize computer simulations. Click here for a description of how computer simulation works.
Perhaps the biggest challenge facing appraisers involves the
absence of reliable empirical data concerning parameters such as transfer and
attrition rates. For a discussion of missing empirical data and calibrated
estimation click here.
Essentially, I believe that Warren Buffet had it right when he said "it is better to be approximately right then precisely wrong. When it comes to business appraisals Rules of Thumb and income methods usually provide exactly wrong precision. Appraisals based upon dynamic modeling techniques provide approximately right values. Having a range of plausible values also facilitates the negotiation of an equity exchange.
Copyright 2018 Michael Sack Elmaleh