Why choosing the earnings basis in your valuation important? Consider this:
Whatever methods you choose for your business valuation, proper selection of the inputs is critical to the accuracy of your results. This is especially important if you are working with the income-based valuation methods such as the Discounted Cash Flow.
Why picking the right earnings basis matters in valuation
Business valuation is about the economic value of the company. So accounting measures of income such as revenue, net income or gross profit are generally not suitable for business valuation directly.
Instead, the discounted cash flow method requires a cash flow based earnings basis for valuation. Why? Because it truly captures the economic benefits the owners can derive from the business.
Earnings basis used in professional valuation
The typical earnings basis used in professional business appraisals is net cash flow. Note that, by definition: it is the measure of earnings that you can extract from the business without adverse effects on its operations.
Net cash flow – removing the capital structure from the equation
Here is how you can calculate the net cash flow of a company:
- Start with the business pre-tax net income
- Add depreciation and amortization expense
- Add tax-affected interest expense
- Subtract changes in working capital
- Subtract capital expenditures
- Add dividend payouts
Note the conspicuous absence of the debt principal repayments or long-term debt increases. In fact, you may notice that the effect of capital structure is completely factored out of the net cash flow. In other words, we determine the cash flow to total invested capital, both equity and debt.
Financing activities such as offering company stock for sale to outsiders or repurchasing stock are usually not a large source of cash flow for private companies. Venture-backed startup businesses do offer their stock to investors. However, the cash proceeds are typically plowed back into the capital expenditures and increased operating expenses to help grow the company. Hence, the immediate effect on the net cash flow is essentially zero.
Business value to total invested capital
This makes sense if you consider business valuation on the typical business enterprise basis. The idea is to determine the total value of the company regardless of how its assets are financed.
Business owners have complete discretion about how to finance the company. Should the business be acquired or merge with another firm, the ownership may well decide to change the capital structure by reducing the leverage, renegotiating loan terms or injecting additional equity capital.
Bear in mind that such policy decisions can bring about positive changes in the long term. However, they do not have an instantaneous effect on business value.