Valuing business equity vs invested capital: why different types of Net Cash Flow?
Half the battle in business valuation is to clearly state what is being valued. Your business appraisal would be misleading unless you define what equity or debt capital you have included in your value calculations.
Equity is just another term for owners’ interest in the business. If you are valuing a corporation this ownership interest is represented by stock.
Many companies use both equity and debt capital to finance operations. Enter creditors, another group of parties interested in the business. Business appraisers usually define the total invested capital as the sum of owners’ equity and long-term interest bearing debt. The value of the business determined based on the total invested capital is called the business enterprise value.
If you are valuing a business using the income-based methods, such as the discounted cash flow, you need to come up with a measure of business earnings and assess its risk, typically in the form of the discount rate.
Net cash flow is the typical earnings basis used in professional business appraisers. To keep things interesting, the net cash flow, or NCF for short, varies depending on whether you value the company to determine its equity value or business enterprise value.
Definition of net cash flow to equity capital
- Net income after taxes.
- Plus non-cash expenses such as depreciation, amortization and any deferred taxes.
- Less net capital expenditures, that is the changes in value of fixed assets.
- Less changes in working capital.
- Plus net changes in long-term debt.
Net cash flow to total invested capital
Now take a look at the net cash flow to total invested capital:
- Net income after taxes.
- Plus non-cash expenses.
- Less capital expenditures.
- Less changes in working capital.
- Plus tax affected interest expense, i.e. multiplied by the (1 – tax rate) factor.
- Preferred dividends, if any.
Since net cash flow is the earnings that can be removed from the business without adversely affecting its operation, the difference between the two types of NCF is who can claim rights to what.
If you are looking at the business enterprise value, then all moneys due to owners and creditors should be accounted for. On the other hand, only the cash flows claimed by the equity holders are included in the net cash flow to equity.
Why net cash flow?
Why do business appraisers use net cash flow? First, NCF is what investors are generally after: money from the business they can pocket for themselves. Owners can enjoy that special vacation or spring for their next big yacht. Creditors get paid for the loans they make available to successful businesses. Everybody gets their share.
Net cash flow is so ubiquitous that most professional business appraisal resources use it as a de facto standard when figuring out the discount rate. So if you build up your discount rate using the standard cost of capital models, net cash flow is the earnings basis that fits right into your business appraisal. As the saying goes, apples to apples.
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