The hard thing of business valuations lies in the great unknown of future cash flows. Although historical operations can provide a sound starting point to determine future cash flows, they can also be very misleading. For example: a biotechnology company in an early stage of clinical trials has no historical positive earnings or cash flows, but it may hold an extremely high market valuation based on the promise of future cash flows from the eventual production and sales of a new drug. Conversely, a cemetery operation may have a one-time (nonrecurring) event due to a liquidation of (long-held) real estate holdings. Hence, future cash flows can be distorted by historical events that are nonrecurring (positive or negative). The key lies in the ability to calculate a core, or operating, cash flow figure on which to base the valuation.
Exploring further, the following common situations and issues regarding how cash flows are determined are provided. These are not meant to be all-inclusive but rather are offered to give you a sense for how cash flows are and should be “adjusted” when used as a basis for determining business value.
Common Cash Flow Adjustments for Business Valuation Purposes
- Expense Savings: A company may be interested in acquiring a business that offers tremendous expense savings opportunities via implementing the concept of economies of scale. By combining the two entities, a once unprofitable business may now actually produce a positive cash flow (which has value).
- Added Expense Removal: Pushing through other or personal expenses in closely held businesses has been around as long as the Internal Revenue Service (IRS). Generally, these are not necessary expenses for the ongoing business to operate, but the owners take advantage of getting the tax break. Removing these expenses to increase cash flows will lead to higher business valuations.
- Potential Cost Increases: Certain companies may be at a stage where a significant reinvestment in capital equipment, assets, and so on is required to continue to support and generate cash flows. These one-time expenditures will need to be factored into a business valuation model to reflect the impact on future cash flows.
- Hidden Assets: Certain assets may have a significant value present, external to the core business. For example, years ago a company may have purchased real estate (for future business expansion) that is no longer needed internally. To an outside party, the value may be substantial, and as such, this hidden value needs to be reflected in the complete business valuation.
- Intangible Assets and/or Intellectual Property: Brand names, research in process, patents, trademarks, contracts for retail shelf space, and similar assets have the ability to generate significant cash flows if managed properly. While one company may struggle with generating adequate cash flows, another may prosper by applying its marketing or financial muscle to their assets.
- Lost Future Business: In service organizations, a business valuation may decrease as a result of a key principal leaving or retiring.
Anyone who has evaluated an acquisition within the service industry knows how critical this issue can be in terms of negatively impacting future cash flows. If a partner of 30 years leaves, chances are a portion of his accounts will also leave.
This sort of list could fill a book if we go through in details. The issue of importance is that in valuing a business, all elements and facts of importance must be evaluated in terms of determining what is the most reasonable future cash flow stream that can be expected.
Step two in the business valuation process is based in how the multiple applied to the cash flow or earnings stream is determined. The following factors all play a role in determining the multiples used. Read on…
Factors Affecting Multiples Used in Business Valuation
- Concentration or Diversification Risks: The higher the concentration or diversification risk, the lower the multiple. Two like companies with the same cash flow stream operating in the same industry may receive different valuations because one company generates its revenue equally from 100 accounts and the other from just 10 accounts (equally). The impact of losing 1 account in 10 is far greater than 1 in 100 and increases the concentration risk.
- Interest Rates: Interest rates, simply stated, represent the cost of capital. Higher interest rates produce lower valuation multiples. Today’s low-interest-rate environment provides for higher multiples; but when the Federal Reserve Board even mentions that rates may rise, well, it should come as no surprise that valuations may be pressured.
- Growth Potential: Higher growth opportunities, which translate into stronger future cash flow potential, will demand higher multiples. Just ask the dot-coms of the late 1990s and early 2000s about how they received astronomical valuations based on the premise of extremely high future-growth rates.
- Length of Cash Flow Stream: Cash flow streams that are longer and more secure, or reliable, will produce higher valuation multiples than shorter, uncertain cash flow streams. If a company has patent production in place for the next 10 years (supporting the cash flow stream) versus 3 years, it’s safe to say the valuation multiple will be favorable.
- Liquidity: If an investment is readily liquid with multiple buyers available, a higher multiple will generally be provided. Illiquid investments with limited market appeal increase risks and drive down valuation multiples.
- Management Continuity: This issue works both ways. Eliminating poor management may actually help the valuation multiple, whereas losing key executives may hurt it. However, if poor management was in place, it’s safe to say the historical cash flow stream was not as strong as it might have been. The valuation multiple really boils down the risks present (perceived and actual). Needless to say, the higher the risks, the lower the valuation multiple received.
In summary, it should be stressed that there are no set rules in the business valuation game. Whereas a seller may want to maximize cash flows and lower the risks (thus increasing the value), the acquirer may want to deflate potential future cash flows and increase the perceived risks (thus decreasing the value). Conversely, an estate may want to justify a lower valuation to reduce potential estate taxes, whereas the IRS may be more aggressive and increase the valuation for obvious reasons. While the basics in the business valuation process remain the same—cash flow and multiples—how these figures are “managed” or “manipulated” represents the real basis of valuing a business. Quite clearly there’s a fair amount of “wiggle room” in coming up with the figures on which the valuation of a business is based. Honest and fair-minded people can and do disagree on cash-flow forecasts and the appropriate multiples for setting a value figure. At the same time, there’s a point beyond which the good faith of a party to the negotiation can be questioned.