Most everyone has heard that the three most important factors in determining the value of real estate are Location, Location, and Location. It is equally true that the three most important factors in valuing an ongoing business are Cash Flow, Cash Flow, and Cash Flow.
So it naturally follows that the most important question a prospective buyer can ask when evaluating a business is: “What it the projected cash flow?”
Many sources talk about the value of a business as a multiple of its cash flow. However, as important as this concept is, there is an alarming lack of consistency about the way cash flow is defined/calculated, so it’s extremely important for the prospective buyer to ask two follow up questions. The first is: “How are you defining “cash flow?”
One of the most commonly used measures of cash flow – particularly for owner operated businesses – is Seller Discretionary Cash Flow (SDCF). This is a measure of all the cash that is generated by the business for the benefit of the owner, prior to deducting interest expense and income taxes, but after adding back all of the seller’s salary, benefits and perks.
Another commonly used measure, especially for larger, investment-grade businesses is EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization. This is similar to SDCF in that the seller’s excess compensation, benefits and perks are added back but a deduction is made for the fair market compensation and benefits of a hired manager.
Other measures of cash flow include: EBITDA less Cap Ex, EBIT, Operating Cash Flow (OCF), Free Cash Flow (FCF), and Net Free Cash Flow (NFCF). Depending upon the specific business, some measures of cash flow will be more meaningful than others. Obviously, using the “right” multiple with the “wrong” cash flow can lead to disastrous results.
Even within the profession of business brokers and M&A advisors all of these cash flow measures are not universally understood, and consistently applied. So this leads to the third critical question: “How did you calculate the “cash flow?”
If you know of someone who’s thinking of selling or buying a business and who might benefit from a free, confidential, consultation with us, have them send an email to Mike Ertel.