Business plan plausibility and company valuation – necessary elements for an appropriate valuation in accordance with IDW S1

published on 23 September 2024 | reading time approx. 7 minutes

Due to the revision of the IDW S1 standard, checking the plausibility of the underlying business plan is becoming increasingly important for the derivation of an appropriate and realistic company valuation.

Importance of the business plan analysis for company valuation

A thorough business plan analysis is crucial for company valuation as it provides insight into a company's future focus, market potential and financial forecast. It enables investors and stakeholders to assess the feasibility and sustainability of business ideas, identify potential risks, and forecast economic viability.

Further, such an analysis enables the person performing the valuation (the valuer) to precisely identify the strengths and weaknesses of the company and realistically assess its market position and future growth potential. A detailed analysis allows checking the plausibility of financial forecasts and identifying potential risks early on. This improves the quality and accuracy of the valuation, thus allowing for more informed recommendations to be derived.

If the enterprise value is derived entirely on the basis of the IDW S1 standard and an expert opinion is prepared, a business plan analysis or plausibility check needs to be carried out by the valuer acting as a neutral appraiser.

Procedure

IDW S1 sets out the principles for the performance and documentation of company valuations, including the valuation of intangible assets. The standard highlights the importance of a well-founded analysis of the company's future earning power, market conditions, and strategic planning. A key element is the checking of the plausibility of the forecasts and assumptions made in the business plan in order to ensure a realistic and traceable valuation.

The general standard for assessing the planning are set out in IDW Practice Note 2/2017 based on the general guidelines. According to these principles, corporate planning should be traceable, consistent and free of contradictions and should reflect the company's intended future development. The management is responsible for the planning and must ensure that it is suitable for the specific case and takes into account all significant developments as well as opportunities and risks. The planning must be complete and up-to-date, including relevant scenario and sensitivity analyses.

When assessing a business plan, the expert also focuses on gaining an understanding of how the business plan was prepared, whereas compliance with certain process steps alone does not guarantee adequacy and plausibility. The assessment aims to determine which objectives are pursued, which information and estimates are included and whether the planning is up-to-date and complete. Companies typically combine top-down and bottom-up approaches to integrate operational and strategic objectives. The planning process is checked for consistency and the correct flow between the subplans such as balance sheet, income statement and cash flow planning, i.e. an integrated planning. The plausibility check consists of three components, which are shown in Figure 1.

1. Formal plausibility:

The expert evaluates the mathematical accuracy of the planning, whereas the type and scope of the analysis depends on the complexity of the planning system. In the next step, the consistency of the assumptions and the traceability of the documentation are assessed. In the case of integrated planning (balance sheet, income statement, and cash flow planning), for example, it should be checked whether uniform assumptions were made in the subplans and whether interdependencies between assumptions in the subplans, e.g. dependence on nominal interest rates and inflation rates or dependence of the volume planning on the existing plant capacity, were considered. Finally, it should be checked whether all relevant information and key data are included to enable a well-founded assessment.

2. External plausibility:

To analyse external plausibility, information on the past and expected development of the company's sales and procurement markets is considered. Market and industry analyses serve as a benchmark for the assessment of the planning assumptions, taking into account macroeconomic, political, social, and technological developments. In addition, macroeconomic factors such as inflation, interest rates, and regulatory changes should be taken into account in the expert's analysis in order to assess their impact on the business model. Additional instruments such as market share, market growth, product life cycle and industry structure analyses can provide further insights. These analyses should refer to the individual elements of corporate planning, as economic developments on the raw materials market, for example, can influence input costs.

The competitor analysis assesses the current status and the expected future development of key competitors, particularly those with comparable business models. Differences in the historical sales and margin development between the company being analysed and the peer companies may indicate structural differences that should be examined. An analysis of the company's strengths, weaknesses, opportunities and risks helps assess whether the strategy formulated in the planning appears feasible.

3. Internal plausibility:

When analysing internal plausibility, the planning assumptions are first compared with the strategic objectives and the operational measures intended by the management. It is assessed whether these assumptions are consistent with the management's explanations. In this process, the logical link between the individual planning components is checked, among other things, to ensure that no contradictory assertions or unrealistic assumptions are included. In this context, it is important, for example, to clarify the management's assumptions regarding planned investments, depreciation and amortisation, and net working capital requirements, and to analyse their plausibility and appropriateness in order to ensure the feasibility of the business plan.

Another important step is the comparison of the planning with the results of the historical analysis, in which historical actual values for relevant planning parameters are compared with the planned figures in order to establish a sound basis for the assessment of future developments. In order to identify the recurring revenue drivers that were effective in the past, the historical figures should be adjusted for one-off, non-recurring or out-of-period items. These are, for example, government subsidies granted during the coronavirus pandemic or extraordinary expenses such as litigation costs. A comparison between historical budgeted figures and the actual performance reflected in actual figures adds planning accuracy to the internal plausibility check. Based on this, the expert draws further conclusions on the plausibility of the future earnings situation expected by the management in the current business plan.

However, the informative value of the historical analysis may be limited, for example, in the case of extensive restructuring measures taken within the organisation in the past or significant changes in the framework conditions, such as changes in legislation or market innovations. In addition, checking the plausibility of historical figures is generally of no use in start-ups because these companies often do not yet have a sufficient history of financial data to identify reliable trends or patterns. Start-ups are usually in the early stages of development, in which initial investments, market entry costs, and rapid growth and change processes have a substantial impact on their financial data. In the case of start-ups, historical figures, therefore, do not provide the necessary basis for reliably forecasting the future performance and success of the company. Instead, the focus is placed more on evaluating the business model, market potential, and strategic plans.

Examples of analyses by Rödl & Partner

When carrying out a business plan plausibility check, Rödl & Partner, in its role as an expert, is guided by the requirements of the IDW PH 2/2017 standard. As part of this plausibility check, comprehensive analyses are carried out to ensure the appropriateness and traceability of the presented planning calculations.

1. Rödl & Partner conducts the formal plausibility check in two steps. The first step consists of checking the consistency of the assumptions made in the subplans and the interdependencies between assumptions.

In the second step, we conduct a technical and mathematical validation of the business plan. This includes a cross-check of input consistency and data flow. In the case of more complex business plan models, Rödl & Partner uses a specialised Excel add-in for verification purposes, which helps to identify errors, inconsistencies and to check the general integrity of the financial data. The software also checks data for potential sources of error resulting from manual adjustments when creating the business plan. The results of the evaluation are then checked internally.

2. The external plausibility check includes customer-specific market and industry analyses, taking into account macroeconomic factors. Market conditions and trends as well as the competitive situation and the company's market position are analysed and evaluated in this process. Rödl & Partner compares analyst estimates, e.g. from STATISTA, with the company forecasts arising from the business plan in order to gain a sound understanding of the market expectations and the accuracy of the forecast values.

Furthermore, we carry out KPI-based comparisons of the business plan with key figures and benchmarks of the industry based on the DuPont model in order to check the appropriateness of the assumptions. The data for the peer group / industry benchmarking are retrieved via the financial services provider S&P Capital IQ. As regards the selection of the peer group, it is generally recommended to make a comparison with companies operating in the same industry that offer similar products, are subject to comparable market structures and whose operational risks are therefore largely comparable to those of the valuation target.

The KPI-based comparisons with the peer group enable a breakdown of specific items and, at the same time, provide background data to determine possible data ranges. Rödl & Partner carries out sales and profitability benchmarking in order to compare the planned sales and earnings growth in the forecast period (see Figure 2).

In addition, a plausibility check of the capitalised earnings value is conducted using multiple-based valuations. This method involves a comparison of key figures such as the price/earnings ratio (P/E ratio), sales or EBITDA and EBIT multiples in order to check the market valuation of the company being valued. The appropriateness of the valuation assumptions and forecasts made in the business plan is ensured by comparing them with peer companies and industry benchmarks.

3. The internal plausibility check includes analysing the business model for regular income and a stable cost structure. Rödl & Partner performs a detailed analysis of the historical revenue streams, the sustainable cost structure, and a trend analysis to check the extent to which the assumptions and forecasts made in the business plan are consistent with the company's historical financial data and whether they reflect the actual business development.

In addition, we review the management's explanatory notes on the business model and the underlying assumptions. Here, it must be possible to derive all parameters and assumptions on the basis of observable and externally verifiable data and traceable methods.

Finally, Rödl & Partner conducts a fair value test to analyse whether the reported values correspond to current market conditions. The fair value test enables an objective and up-to-date valuation of assets and liabilities based on market conditions. It promotes transparency and comparability in financial reporting and ensures that a company's financial information reflects the real current market situation. This can be done on the one hand by making a comparison with similar transactions on the active market or by discounting future cash flows to present value.

Conclusions

In the company valuation process, checking the plausibility of a business plan is a decisive element for the expert to ensure a proper valuation. The expert must thoroughly review and check the plausibility (externally, internally, and formally) of all assumptions and forecasts. By comparing the business plan with historical data, industry benchmarks and macroeconomic factors and by carrying out sensitivity and scenario analyses, it can be ensured that the business plan is plausible, consistent and traceable. Rödl & Partner at all times follows the requirements of the IDW PH 2/2017 standard and efficiently implements the plausibility checks with targeted analysis steps and transparent documentation.