Business Plans for Valuation Purposes
TP Ticker / March 2022
In business restructurings, the transfer pricing is typically based on an income-approach valuation using a business plan prepared by the management of the restructuring corporation. The forecasts in such plans are based on premises and assumptions that may substantially influence the outcome of the valuation. Accordingly, the reasonableness of these assumptions and the reliability of the forecasts often become the focus in transfer pricing audits as well as the valuator who may or may not have made sufficiently use of his authority to adapt unreasonable assumptions and thereby adjust the management plan for the purpose of the valuation.
On this topic, typical mistakes experts make when adjusting business plans for valuation purposes, David Klee and Thomas Straßer published an article in the recent issue of “BewertungsPraktiker”. The authors outline the general methodology applied by valuators when judging the reliability of a management plan, which is based on the examination of past business plans. Here, they explain the general concept of the analysis of past forecasts and the identification of deviations between plan and actual, distinguishable mainly into systematical and non-systematical deviations. Based on this, they explain typically observed errors, thus situations where valuators may erroneously adjust the business plan based on a faulty assessment of the past forecast reliability.
Main purpose of the analysis of past business plans is identifying the recurring success factors of the business by correcting for extraordinary influences. Important part of this process is to develop an understanding of which future developments were predictable for management at the time of developing the respective plan. To develop a base of comparison between the forecasts and the actual results achieved by the enterprise, it is necessary to adjust for all extraordinary, non-recurring effects in a first step and then readjust, where such effects were considered during the planning process of the management. In practice, the period analyzed typically ranges from 3 to 5 years. This period should cover the full cycle, where industries are dominated by such. Where too short, the valuator runs an increased risk that the time period is not representative.
Comparing the budget and actual figures, the focus is on determining primary value drivers – such as the price and margin framework – and the significant revenue and expense items. The identified planning errors can then, on a high level, be divided into systematic and non-systematic errors. Systematic errors in this sense also include purpose-oriented target setting. This occurs with the intention to motivate employees and may lead to deviations from middle expectations, either upwards – where the firm is risk-oriented – or downwards- risk-averse.
Based on these fundamental explanations, the authors outline typical errors that may lead to inappropriate adjustments of the management plan that feeds into the valuation. One such issue is laying the focus on profit measures instead on individual accounting items. Other potential issues include the use of unsuitable reference values when calculating ratios and sign errors, where quantities can be either positive or negative. Hindsight errors and the use of erroneous comparisons are further possible defects of the analysis. The authors emphasize, that a mere line-up of deviations between previous management plans and actual results is not a sufficient basis for justifying adjustments of the plan used for valuation. Rather, as long as the management plan is based on reasonable and justifiable assumptions, it should be used.
In our view, the article provides an excellent overview about the topic. While it is aimed at business valuation in general, thus with a market value as basis, it is no less applicable for business valuations that are prepared for transfer pricing purposes. The peculiarity of a transfer pricing valuation compared with a market value analysis is that with the arm’s-length price, the special conditions of the individual transaction partners are to be considered. Especially under such a precondition, the reasonable expectations and assumptions of the parties at the time of entering into the transaction regularly become a point of discussion.
The article “Analyse der Planungstreue, häufige Fehler und ihre Auswirkungen auf die Unternehmensbewertungspraxis” by Klee and Straßer was published in BewertungsPraktiker 1/2022 on page 6 through 12.