There are various approaches to valuing companies. For privately-held companies that are established and generate income, normalized net operating cash flow is usually the starting point for valuation. All other qualitative issues related to the merits of a company, such as its market position, intellectual property, etc. can be factored in but the bottom line is that the more cash a company generates, the more it is worth. Business owners should understand that cash flow is not the same as the net income on your income statement. Normalized Net Operating Cash flow is derived by adjusting the income statement for certain items that are either non-cash related, or unusual or discretionary. This process of adjusting is called “recasting”. It takes an experienced analyst to do this correctly.
Normalized Operating Cash Flow: Normalized operating cash flow is the cash flow that can be expected of the company under “normal” circumstances. It excludes unusual and discretionary expenses, as well as non-cash items.
Adjusting the Income Statement: To calculate normalized operating cash flow, start with net income from the income statement. Then add back non-cash expenses such as depreciation and amortization, and discretionary items like interest (how a company is financed is a discretionary decision), charitable gifts, personal expenses, and rent that is greater than fair market rates. Non-recurring expenses such as a company move or unusual repair may also be added back. Adjustments can also be made for gains or losses on sales of assets and income or expenses not related to the operation of the business such as interest income.
Adjusting for Owners’ Compensation: Often owners compensate themselves more or less than “fair market compensation for owners’ work”, which is what the owner could expect to pay someone hired to perform the owner’s duties. The way to adjust for this is to add back the actual owners’ compensation, and subtract the fair market owners’ compensation.
Discretionary Cash Flow and EBITDA: After adding back the actual owners’ compensation (including other perquisites such as auto expenses, insurance, etc.) and the other adjustments mentioned above, the resulting figure is called Discretionary Cash Flow (DCF). It is one cash flow measure used in appraisals. After subtracting fair market owners’ compensation from the Discretionary Cash Flow, the second cash flow figure derived is Earnings Before Interest Taxes Depreciation and Amortization (EBITDA). EBITDA represents the normalized operating cash flow that can be expected from the business. By making these adjustments, companies can be using consistent measures of cash flow, whether it’s DCF or EBITDA.
Keeping Track of Expenses: Of course, this is all possible only if you have the ability to find all the adjustments to make. Some of them are automatic line items in most accounting systems, such as amortization, depreciation, and interest. Others, such as officers’ compensation, are available in others. Some may not be separately identifiable in any accounting system and must be tracked by either creating special accounts in your accounting system or by a manual method. Keeping track of your personal expenses in the company, as well as unusual or discretionary items, may be a worthwhile effort as it will help you enhance the value of your business in the long run.
After recasting the income statement with all adjustments to net income, the resulting normalized operating cash flow may be evaluated to determine the company’s worth. Companies with low net income but high debt service, equipment depreciation or other expenses may actually be worth more than they initially appear.