Vaguely Right or Precisely Wrong about Cash Flow

Al StatzWarren Buffet once quoted the economist John Maynard Keynes, “I would rather be vaguely right, than precisely wrong,” in describing how he determines the appropriate cash flow measure of a company.

Indeed, determining the value of a business is not a precise exercise.  However, neither is the process random guesswork. After assessing the facts and circumstances of the business, the appraiser’s goal is to find a value that represents what hypothetical or actual market participants could be expected to pay for the business or an equity interest therein.

When it comes to understanding financial performance, privately held businesses present several challenges not present in public companies. For beginners, private companies are not held to the same financial reporting standards. Hence, financial statement quality varies widely from business to business. Business appraisers and M&A advisors must look at the reported numbers and make a series of adjustments before applying valuation methods. Valuation analysts typically make four types of normalization adjustments to arrive at a true measure of cash flow (or some other economic benefit stream).

Four Types of Normalization Adjustments

  1. GAAP related — typically for comparison with industry peers
  2. Non-recurring and extraordinary items
  3. Non-operating assets, liabilities, income and expense
  4. Control-related — adjusting owner benefits to market or reasonable replacement values

Owners, investors, CPA’s, attorneys, lenders and other market participants are often surprised how much work goes into investigating and adjusting financial statements before business valuation methods can be applied. Often, the smaller and more closely held a business is, the more normalization work will be required.

“Often, the smaller and more closely held a business is, the more normalization work will be required.”

There are other areas where the need for investigation and professional judgement increases in small business valuation. Small private companies seldom have the same quality of systems, and usually have more reliance on few products, employees or customers management, which increases uncertainty and adds to the risk analysis. And they rarely have defensible growth projections. The growth rate and risk score affects the discount or capitalization rate used in the valuation. And using valuation simplistic formulas, “rules of thumb” or hearsay are almost sure to yield precisely wrong results. Whereas, an accredited and experienced appraiser using appropriate valuation analysis, professional judgement, objectivity and common sense will give you an opinion of value that more accurately reflects market reality.

Exit Strategies brings independence and over 100 years of combined professional expertise to every business valuation engagement. Contact Al Statz with any questions or for a free confidential consultation on a potential business valuation or M&A need.