Reviewing quickly, we discussed the difference in a sale price and the business value. Here in article #2, we look at the methods Business Valuators use to establish a value when there is no actual buyer. Of course, the techniques are intended to simulate the rational thinking of a generic buyer. Professional valuators may apply 2-5 different methods to develop values and pick the best suited. So off we go to Valuation 101.
Cash Flow Based Valuation Techniques
Sound company valuation techniques all include a combination of Cash Flow and Asset Value as the primary determinants of value. There are several specific cash flow related calculation methodologies, each favored by different analysts, advisors, and courts. In many cases the choice of a favored technique may be more of a reflection of the desire for a specific outcome than true superiority of the method. A low valuation may be desirable to minimize estate taxes. A divorce proceeding may have one party wishing for a high valuation and the other a lower one.
There are two fundamental elements of value that are derived from cash flow and they are usually considered incontrovertible. First, value is all about how much cash a company can generate, commonly known as “cash flow” or “cash earnings”. Second, value is about the relative perceptions of the certainty of the “cash flow”. These two ideas intersect as a valuation that incorporates the future ability of the business to generate cash flow.
Looking first at the analytic methods of determining a company’s value will help to sort out some of the confusion about value. Virtually every financial valuation technique includes the idea that value is tied to future cash flows. This principle is a fundamental premise of modern economic theory (i.e. an investor wants to get a cash return on his investment). A first step in this process is separating the impact of the capital structure, the amount of the company’s debt and equity, on the cash flow of the company. Different techniques do this in a number of ways but the objective is the same: to state the cash flows on an “apples to apples” basis, adjusting for the specific debt and equity structure that exists in the company under the current owner. You will see discussions of weighted average cost of capital, leverage adjusted betas, after tax cost of capital and other financial manipulations that can boggle the mind!
One of the simpler, and thus more common, techniques is to calculate cash flow before the cost of interest and taxes, usually stated as earnings before interest and taxes or EBIT. A close cousin to EBIT is EBITDA which also adds back the non-cash expense of depreciation (and amortization if present) to calculate cash flow. We will return to the EBIT/EBITDA distinction and the vagaries of free cash flow in another context a bit further on. For now, we can recognize that “cash flow” is an underlying driver in every valuation.
The second driver of value associated with cash flow is the degree of uncertainty about the “cash flow” in the future. This driver follows the adage “less is more”. In this case, less uncertainty translates to an investor being willing to value the future cash flows higher and pay more for them. On the other hand, the more uncertain the future cash flows, the less an investor is willing to pay for them. It is a given that the future, however calculated, is a guess. The guess may be a very easy one based on an extraordinarily stable history and a dearth of external factors that could impact the future. It can also be a very difficult one due to erratic past performance and numerous internal and external unknowns.
An Idea with many Aliases
Earnings, EBITDA, EBIT, EBITDAR, Normalized Earnings, Operating Earnings, Operating Cash Flow, Free Cash Flow, Leverage Adjusted Earnings, Trailing Earnings, Pro Forma Earnings, Pre Tax Earnings, Net Income, Owner’s Benefit, Owner’s Consideration, Owner’s Discretionary Income…. In the world of business and securities valuation, a company’s ability to “make money” comes under many names.
In business valuation jargon, the value of future earnings is usually computed as a multiple of some sort of a measure of current “cash flow”. The terms that are used are numerous and the math is often a little fuzzy and can depend on whether you are a buyer or a seller, but a price to earnings ratio, a multiple of EBIT or EBITDA, a multiple of revenue, or a capitalization ratio, are commonly used to determine value. In these calculations, the higher the multiple, the higher the value assigned to the future cash flow, and the higher the value of (and presumably the more attractive) the company.
A student of corporate finance will recognize that these multiples translate the expected future stream of cash into an amount you expect to pay. Presuming that all can agree on what the future cash stream will be, than the amount you are willing to pay is determined by the perceived uncertainty that it will actually materialize and yield the expected payoff on the bet in the future. A bet on red or black at roulette has a better chance of winning than a bet on a single number!
In technical terms, the “multiple” is a mathematical result of discounting the future cash flows by an uncertainty factor known as a risk adjusted discount rate. This rate is then divided into a current “cash flow” measure. For simplicity in discussion, usually at cocktail parties or the golf club, the valuation is expressed in terms such as 5 times EBITDA or 15 times net income.
Underlying the Idea of a Multiple
Valuations expressed in terms of a multiple of current “cash flow” derive not just from our innate desire for a simplified form of communication but from economic theory that states that the value of a future stream of earnings is proportional to the “cash flow” times a multiplier. The multiplier is derived from the cost of capital and any expected growth in the future earnings stream [M = 1/(r – g) where r is a risk adjusted cost of capital and g the steady state growth rate of “cash flow”].
In summary, the cash flow methods focus on the income statement of the company, its cash earnings, and an appropriate risk factor to determine the value of a company.
Asset Based Methodologies
In the context of determining market values of a transaction, the underlying asset value is an important consideration. In certain situations, and in some industries, an asset-based value calculation becomes the methodology of choice for valuing a company.
Asset valuations generally follow one of two paths – the accounting approach or the fair market approach. The traditional GAAP balance sheet can be viewed as a proxy for the fair value of the assets of a company less any debts owed, and is sometimes used as a measure of value of the company. This is known as the book value of the company. A severe limitation of this approach is that under accounting rules, the fixed assets of a company (generally land and buildings, and machinery and equipment) are valued at historical cost less any accumulated depreciation that has been recorded in the financial statements. This can significantly understate the value of the assets because it ignores the impact of inflation over time. Machinery and equipment that has a substantial current market value may be included on the balance sheet at no value if it is fully depreciated. This often occurs with smaller companies that tend to use accelerated tax depreciation rates for financial reporting purposes. In addition, land and buildings often have a lower book value than current market value.
A modified version of this approach restates the value of the fixed assets to market value to reflect a more accurate value of these assets. The increase in value due to the restatement to market values results in a corresponding increase to stockholders’ equity or the book value of the business. The value of the current assets (cash, accounts receivable, minus account payable, and inventory) are then added to the adjusted fixed asset value to get an adjusted book value.
Reading a valuation report is often a daunting task; valuation standards and texts run thousands of pages! Just remember every technique is either trying to calculate the cash a business will generate that you can take home or the cost of replicating all the assets of the business. Its either cash flow value or asset value!! Modified, adjusted and tweaked until the picture looks just right to the valuator!
Todd Peter is a FocusCFO Principal based in Cleveland, OH.