Valuing a business? Use the net cash flow to get it right.

What is the role of net cash flow in business valuation? Just talk to a seasoned investor who puts money into public company stock. And you will surely hear about various valuation multiples they use to figure out the value. Ratios of price to earnings, EBITDA, gross revenue or net sales are common knowledge.

What makes these valuation multiples work so well? The fact that all publicly traded companies must report their financial results in strict accordance with standards such as GAAP in the USA or IFRS world-wide. This consistency in financial reporting gives investors the confidence in comparison shopping.

First, you pick your favorite valuation multiples.  Next, apply them to the target company’s financial performance figures.  And voila – you have a smart estimate of what your target company’s price per share ought to be.

Why market comparison is challenging in private company valuation

Things get more interesting when it comes to market comparisons for privately owned companies. Now such firms do not sell their stock to the public. So they do not have to report their financial results publicly. No 10-Q or 10-K reports for your average mom and pop operation.

Business owners try to minimize taxes

Private business owners have a very different set of goals that set them apart from public companies. Most importantly, minimizing taxable income is king, increasing earnings per share – not so much. On the other hand, public multinationals play a complex game of maximizing earnings per share and avoiding taxes by moving investment into jurisdictions with little or no taxes.

Private company financials do not comply with GAAP

Many small business owners turn to their accountants for help in reducing the tax burden. Since the tax authorities do not require GAAP compliance for these companies, aggressive deductions are very common. Think accelerated depreciation schedules, creative business expenses, and just about any other trick in the book to cut down on taxes.

Pass through entities are the norm for private companies

Most private businesses are pass-through entities that do not pay taxes directly. Rather, S-corporations or LLCs pass income to the business owners who pay taxes on their share of business earnings. This is quite different from the public companies that are usually structured as tax paying C corporations in the USA.

So if you pick several private competitors in your industry sector, and try to figure out the valuation multiples, you run into the challenge of data reliability. The typical accounting measures of business earnings may be misstated so much as to be misleading.

Private business financials must be normalized before business valuation!

This is the reason professional business appraisers go through the process of financial statement normalization. You start with the typical income statement and balance sheet numbers.  And then make a number of adjustments in order to figure out the true income generating capacity of the subject company.

One widely accepted measure of private company earnings is the net cash flow or NCF for short. NCF is the type of business earnings the owners can pocket without impairing the company’s ability to go on functioning.

For example, you can not short change the business on capital investments in inventory or business equipment and machinery it depends on to run. Nor can you forgo the needed equipment repairs, at least not for long.

Net cash flow as the measure of earnings in business valuation

So the reason for figuring out the net cash flow as the earnings basis in your business valuation is to base your calculations on something that reflects the true earning power of the firm. Peel off the veneers of creative accounting and you can reveal what sort of financial power the company really has.

Net cash flow is the typical earnings basis used in valuing private companies by income-based methods such as the discounted cash flow. To figure out the company’s value you focus directly on the business’s earning capacity rather than comparing it to its industry peers.

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