Strange as it may sound, different appraisers valuing the same company’s cash flow — a key component of business value — can come up with different numbers. This doesn’t mean that one expert is wrong, but instead that the process of valuing cash flow requires valuators to make highly subjective decisions. Not only might a buyer’s valuator disagree with a seller’s valuator, but experts working for different prospective buyers can arrive at different conclusions.
What buyers want
Cash flow commonly is thought of as a company’s net income (sales minus expenses and income taxes), plus noncash expenses (primarily depreciation and amortization) minus principal liabilities, working capital, and capital expenditures, such as new equipment. The resulting free cash flow is the amount a business’s owner could remove each year without compromising the company’s ability to function and grow.
Most buyers hope to realize cash flow equal to their original investment, plus interest, within five years of making an acquisition. By forecasting five years’ cash flow and reducing that amount by the interest the buyer expects to receive, you can determine a company’s present cash value or the amount the buyer is likely willing to pay.
To calculate the value of a company from the cash flow it generates, a valuator performs a discounted cash flow analysis (DCFA). This expert estimates future cash flow over a period of years, and then discounts the combined cash to determine the present value. The “discounted” portion reflects the risk of actually receiving the full amount at a later date.
Choosing a time period
In theory, a DCFA consists of two seemingly simple steps, but in reality it can be a complicated calculation. First, valuators decide the number of years to include — typically five and no more than 10 or fewer than three. The further out experts project, the more work they’re required to do and the less accurate the results are likely to be.
Experts factor in assumptions about future sales, operating expenses, tax rates and capital expenditures for each year included in the analysis. To the sum of these cash flows, some valuators add an estimated value of the company’s net assets at the end of the period being analyzed.
However, estimating future results can be tricky. This is because company specific, industry and other factors can cause results to differ from assumptions. A DCFA is only a tool or basis for valuation, and minor changes in input can significantly affect projected outcomes.
The second major step in a DCFA — choosing the appropriate discount rate to apply against estimated future cash flows — is how valuators try to account for the uncertainty of projected results. While cash flow estimates attempt to quantify returns, discount rates try to quantify risk. If the discount rate is set too high, a valuation is likely to undervalue the business. Conversely, if it’s set too low, the resulting market value will be too high.
Some discount rates are based on complex mathematical models, while others rely on industry averages that have been tracked over time. Frequently, buyers analyzing a business for potential acquisition use a “weighted” discount rate, which factors the buyer’s average borrowing cost into the calculation to determine the minimum required return to satisfy providers of capital. Two prospective buyers with similar cash flow assumptions about a business could, in fact, arrive at different valuations because they borrowed differently.
Arriving at the negotiation table with a range of values in hand will help you evaluate your buyer’s or seller’s offer. Keep in mind, however, that many variables determine a company’s ultimate sale price, including the state of the general economy and M&A marketplace, and a business’s unique offerings, such as trademarks or unique products.
Disclaimer: All content provided in this article is for informational purposes only, and is subject to change. Contact a DS+B professional before using or acting on any information provided in this article