Beware the Baseline Year
Factual definition
Beware the Baseline Year is the diligence warning for a seller who takes a single unusually good year and forecasts it forward as if it were the run rate.
Forecasting from an unusually strong year
A business with choppy revenue and uneven earnings has one really great year, and the teaser forecasts that year out into the future.
How Shayne Fitz-Coy uses Beware the Baseline Year
The vast majority of teasers you will see have those characteristics. One good thing happened, and they use that year as the baseline.
Separate repeatable sales from the exception
Hypothetical example. All amounts are US dollars.
A seller reports annual revenue of $10 million, $10 million and then $14 million. Assume the last year includes a $4 million order that the customer confirms will not repeat.
The seller forecasts 10% growth by applying that rate to the full $14 million.
That forecast produces $15.4 million. If the same 10% growth assumption applies only to the $10 million recurring base, the result is $11 million.
The $4.4 million difference is the nonrecurring order plus the growth applied to it. Neither forecast is validated merely by doing the arithmetic.
Ask for the order history, customer confirmation, current backlog and explanation of what drove the strong year. A new multiyear contract or a lasting capacity increase would require different treatment from an order known not to repeat.
The correction is to investigate the starting point, not automatically average the past three years. Once the revenue assumptions are supported, examine their margins, costs and cash requirements separately before using them in an investment case.
Translate the missing order into earnings before changing the price
Suppose the hypothetical US$4 million nonrecurring order above contributed US$1 million of EBITDA after all costs attributable to it. Assume its removal does not change any other revenue or costs.
Capitalizing that US$1 million at an assumed 6x EBITDA would add US$6 million to the enterprise-value indication. If the earnings will not repeat, that value needs another supported source of future profit; repeating last year’s order in the spreadsheet does not provide one.
The margin assumption matters: US$4 million of revenue is not US$4 million of EBITDA. Establish which costs disappear with the order and which remain before estimating normalized earnings.
Where Beware the Baseline Year fits
Explore this term in the glossary cloud →