Business valuation pitfalls
Although price-to-earnings multiples may be shared by word of mouth in certain industries by business owners and business brokers may share, valuations based solely on these oversimplified rules of thumb won’t pass muster in court. And especially when pricing a business for sale, they shouldn’t be used as a sole method of valuation.
Instead, a formal cash flow analysis can provide a more reliable estimate. Here are some important considerations that may be missing if you use the terms “earnings” and “cash flow” interchangeably.
1. Depreciation expense vs. capital investments
When calculating earnings, depreciation is a noncash expense that’s subtracted from revenue. In theory, depreciation expense is taken against fixed assets (such as vehicles, equipment and leasehold improvement) over their useful lives. The reason is that these assets are used to generate revenue over many years, and, under accounting principles, expenses from an asset are “matched” to the period in which the asset generates revenue.
However, in reality, many companies use accelerated depreciation methods, which overstate depreciation expense in the early years that an asset is owned. Depending on the age of a company’s assets, depreciation expense may under- or overstate the need for capital investments — which is what valuation experts really want to capture when estimating future cash flow.
Moreover, past capital expenditures may be higher (or lower) than what will be needed in the future. For example, a start-up that has invested heavily in fixed assets in recent years may not need to make any major purchases for several more years. Alternatively, for a company that’s at full capacity to achieve its growth forecasts, it may need additional equipment or a plant expansion.
2. Changes in working capital
Cash flow estimates include changes in working capital, but earnings estimates don’t. In order for a company to fund its cash flow cycle as it grows, it needs to invest working capital. That is, management needs to purchase inventory and pay salaries, rent and other operating expenses. There’s a lag between billings and collections on both the receivables and payables sides of the business.
For entrepreneurs and other investors in private businesses, cash flow shortages are a common frustration. The faster a business grows and the more unexpected obstacles it experiences, the more working capital it needs to stay afloat. Established businesses tend to generate sufficient cash and stockpile it, so they generally experience fewer cash flow shortages than high-growth ones.
3. Debt service or proceeds
Rather than using additional capital contributions from owners, some companies choose to finance fixed asset purchases and changes in working capital with loans. Proceeds from debt are cash inflows — but, eventually, loans need to be repaid (cash outflows). The increase or decrease in cash from debt financings is relevant to investors, but it’s not accounted for in earnings.
Here’s where things get a bit complicated: Cash flow may be calculated for equity or invested capital (debt and equity) investors. When calculating equity cash flows, interest expense, debt service and debt proceeds are factored in. This approximates the cash flow that’s available to pay equity investors each period.
Conversely, interest expense (net of the tax benefit) is added back and no adjustment is made for changes in debt when calculating invested capital cash flows. This approximates the cash flow that’s available to pay both equity and debt investors. Interest-bearing debt must be subtracted from the preliminary estimate of value to arrive at the value of equity when using invested capital cash flows to value a business.
Cash is king
Contact a valuation professional for help converting earnings to cash flow, because doing so can provide a reliable estimate of value.
A company’s income statement casts light on its earnings, but that’s only part of the story. Investors are typically more interested in how much cash it will generate in the future than its earnings reports.