By Gregory R. Caruso, JD, CPA, CVA
Successful businesses are usually valued by estimating a future cash flow using either an income approach or a market approach. The goal is to select the best cash flow to reflect the true earnings power of the business for the size and type of business and the valuation risk data available. The risk in business valuation is that projected cash flows will not be met.
Examples of alignment between cash flow and risk adjustment/ measure:
Market Method Revenues —– Total Revenues
Market Method EBITDA —– EBITDA
Market Method SDE —– SDE
Capitalization of Earnings —– Usually After Tax Cash Flow from historic data
Discounted Cash Flow —– Usually after Tax Cash Flow from projections
In all cases, the proper selected cash flow for business valuation is forward looking. We look at the past because usually that is the best indicator of the future. (This is not always the case as Covid-19 has shown us but it usually is the best that can be done.) Valuators also look at company staffing depth, systems, projections, industry growth rates and other data to estimate future cash flow.
Cash Flows Used in Business Valuation
Here are a few cash flows frequently used to measure value.
Revenues are easy to agree on but not always an indicator of the money making ability of the business. In this case, value is much more influenced by the bottom lines, namely the income generating power of the business as opposed to the pure revenues. But, sometimes revenue is all there is compare. Certain industries such as accounting, insurance, and financial planning will often be valued by revenues.
EBITDA ( Earnings Before Interest, Taxes, Depreciation, and Amortization)
This is viewed as an indication of the income that could be available for distribution to an investor. This cash flow assumes that the company is fully managed–namely an investor that owns the company will not be working there as all management required to make the cash flow is in place. We use EBIT (Earnings Before Interest and Taxes, which does not add back depreciation and amortization) for some industries with large equipment investment requirements. If a company must continually buy new equipment, then depreciation may not be available for distribution to investors. This cash flow is generally used for businesses that are large enough that they are likely to have a corporate or private equity group type buyer that wants a fully managed business.
SDE – Sellers Discretionary Earnings
In the simplest form, this is EBITDA plus all the ways one owner makes money from the business. If there are multiple owners, the labor value of all owners beyond the first one has to be compared to salaries. Some owners are paid more than their labor value, some less. This is then added to or deducted from the profits. For smaller owner-operated businesses (whose fair market buyer is likely to be another individual) this can be the most accurate cash flow available.
After Tax Cash Flow
This measure of income is used many times with Income approach valuation methods. Income approaches tend to use buildups of layers of risk to determine a capitalization or discount rate. In effect, that rate is what an investor would need to invest in the business out of all investment options in the world. Those risk levels primarily come from public market data. Therefore, they are viewed as being after tax since public company earnings are after tax and after tax cash flow is used as it is similar to public company earnings.
Some industries use gross profits after deducting the cost of goods sold. While not a bottom-line profit, it can show if the product or service of the business is profitable enough to pay for overhead and profits if volume can be increased.
Normalizing the Cash Flow
Whichever cash flow you use you will hear the term, “Normalizing the Cash Flow.” When a cash flow is normalized, it is adjusted to be apples-to-apples to reflect the earnings power of the business and be comparable to the risk factor source data. Once more, cash flow in business valuation is forward looking so the valuator is always trying to estimate future cash flow in these adjustments. Normalizing adjustments have three main categories.
- Comparability Adjustments — these are made to make the data comparable to the risk data. For instance interest is often added back as an owner does not have to take on debt (under valuation theory anyway).
- Non-operating or Non-recurring adjustments – these are also called one-time adjustments. For instance PPP loan income is a one-time adjustment so it is removed for valuation purposes as they are not likely to happen again in the future.
- Discretionary Adjustments – these are adjustments that usually benefit the owner or the owner chooses to pay for the expense but it is not required to generate the earnings of the business. This can be things like the owner’s pension expense, underemployed family members on payroll, owner’s health insurance, etc.
In summary, the valuator selects the cash flow that will best represent the earnings power of the business being valued and has sufficient data to generate a valid estimate of value. The valuator then normalizes the company cash flow to improve comparability and show true earnings power. Finally, the normalized cash flow is adjusted by the risk adjustment to determine value.
The last step is always stepping back and asking, “Does this make sense?” Namely, is there a sufficient return to the owner/operator or investor for the risk of the investment? As I always say, valuation is an art and not a science, and often experience and practice helps with understanding the art. Contact me to learn more about my valuation services or learn more about the Art of Business Valuation in my book.