If your company has earnings and cash flow, the Capitalized Net Cash Flow Method may be an appropriate method to determine the value of your business.
“It’s one of the methodologies under the Income Approach, in which an indication of value for an entity is based on its earnings and cash flow,” says Eddie Blaugrund, CPA/ABV/CFF, CFE, an associate director in the business valuation and litigation consulting services group at SS&G.
“When you look at Capitalized Net Cash Flow, you’re looking at the company’s earnings and cash flow and saying that what has happened historically in the company is a good indication of what’s going to happen in the future.”
Smart Business spoke with Blaugrund about the Capitalized Net Cash Flow Method of business appraisal and how an appraiser can use it to determine the value of your business.
In what situations would a company need an appraisal?
An appraisal can be done for a variety of purposes, such as divorce, estate planning or for the sale of a business. For domestic relations purposes, a privately held business may be one of the largest assets owned by one or both of the divorcing parties and may need to be valued to help the trier of fact in the property division process.
It can also be a valuable tool for business owners looking to sell their business. For instance, it can help an owner establish a price to begin negotiations with potential buyers or it can assist the business owner in understanding the value drivers of their company.
How does the Capitalized Net Cash Flow Method work?
Please understand that a complete discussion of this method can’t be done in a single article, so I will hit a few highlights of the method instead. Generally speaking, an appraiser will analyze three to five years of historical financial statements for the subject company to get an understanding of its financial performance history. During this process, the appraiser will look primarily for two things, items that are nonrecurring in nature and items that are not occurring at market rates.
Something that may be nonrecurring in nature might involve a company’s legal expenses. For example, in four of the last five years analyzed, the business’s legal expenses may have averaged $50,000 per year. However, in one year the expenses may have increased to $250,000. Upon discussion with company management, it may come to light that this increase in legal expenses is the result of a one-time lawsuit involving the company, and this type of litigation happens infrequently. As a result, the appraiser may add back the extra $200,000 to historical earnings as a nonrecurring item.
An example of items that may not be occurring at market rates is shareholder/officer compensation. It is not uncommon to see a shareholder who is president of a privately held company, pay himself $500,000 per year for his role in the company. However, if the appraiser performs market compensation research and finds that the fair market wage for a president of a company with similar financial/operational characteristics, within the same industry and geographic location is actually $200,000, then the appraiser may add back the extra $300,000 to historical earnings, as it appears this shareholder is paying himself more than the going market rate.
Once normalized earnings are determined, the appraiser may (or may not) tax effect these earnings, then make certain other adjustments to convert these earnings to net cash flow. These cash flow adjustments may include adjustments for noncash items, working capital, debt service and capital expenditures. Once the net cash flow benefit stream is determined, a capitalization rate (valuation multiple) is applied to said benefit stream to arrive at an unadjusted initial indication of value for the company.