I’m sure you’ve heard it said that the three most important factors in determining the value of real estate are: Location, Location, and Location. While many factors contribute to the value of a property, such as square footage, # of bedrooms, # of baths, other amenities, finish materials, etc.; location does seem to be by far the most important.
Businesses are similar: while many factors contribute to value, the three most important factors by far seem to be: Cash Flow, Cash Flow, and Cash Flow.
It’s important to note that when valuing a business, the focus is on future cash flows. A great deal of time and energy is spent analyzing, understanding and recasting the business’ historic cash flows, but its value is based on its expected future cash flows.
There are two commonly used measures of business cash flow. For smaller, owner-operator businesses the most common metric is SDCF, or Seller’s Discretionary Cash Flow. This is amount of cash left over after the business owner has paid all of the normal (extraordinary items may be adjusted) fixed and variable cash expenses (depreciation is not a cash expense) of the business, but before he/she pays: (1) any wages, salary, benefits or perks to him/herself, (2) any interest, or (3) any income taxes. This is an estimate of the gross amount of cash that a new owner will have to cover financing costs, invest in growing the business, and keep for him/herself.
In larger businesses, where the buyer will most likely not be engaged as an owner-operator, the most common metric is EBITDA, or Earnings Before Interest Taxes Depreciation and Amortization. As the acronym suggests, this measure is similar to SDCF, but an additional amount has been subtracted to account for the fair market value of a general manager’s salary, benefits, and perks.
Therefore, one of the most important questions a potential business buyer can ask is: What measure of cash flow are you using for this business? An excellent follow-up question, just to be certain everyone is on the same page, is: Precisely how did you calculate the cash flow?
If you , or someone you know, may be thinking about buying or selling a business, and who might benefit from a free, confidential, consultation with us, please contact me directly at 813.299.7862, or firstname.lastname@example.org
By: Mike Ertel, Transworld M&A Advisors