March 18th, 2007 | Income Approach & Methods | Market Approach

A number of recent reviews of other’s reports have prompted me to make this post.  There seems to be a segment of the valuation world that does not understand the definition of operating assets or operating cashflows. There are three principal components on the left side of the accounting equation or balance sheet that equal the right hand side of the accounting equation or Market Value of Invested Capital (MVIC): Working Capital, Fixed Assets and Intangible Assets or BEV. This is easily seen in the discussion of cashflow in the annual Ibbotson Yearbook or in classic valuation texts such as Pratt’s (4th Edition, page 70) or Hitchner’s (2d Edition, page 118). Discount rates developed from Ibbotson data therefore apply to ALL operating cashflows, not just to, for example, fixed assets and intangible assets.

Near as I can tell the "confusion" or mistakes result from looking at market data where the transaction price excludes working capital, as it often does for many small businesses. For some reason, the individuals making the mistake assume that because a small business transaction does not include working capital, the cashflows from that business do not require working capital! In fact, the purchaser of a small business who does not acquire the working capital MUST infuse that working capital.  Thus, for market data, one would have to add working capital to the values to get the MVIC. This must NOT be done however for the CCF or DCF methods, which ALREADY INCLUDE the working capital value.

When one derives valuation multiples from transaction databases that include operating cashflow and transaction data with only fixed assets and intangibles, the numerator (the transaction price) is lower than the MVIC of the business, while the denominator (cashflow) is the same.

For example, assume the business has cashflow of 3 and transaction value of 12; required working capital is 3 so MVIC is equal to 15.  Thus, fixed assets and intangibles  have an apparent valuation multiple of 4 times operating cashflow, while MVIC would have a multiple of 5 times the same operating cashflows. Inexperienced or poorly trained valuators confuse the different numerators when trying to compare transaction data to income methods.  All things being equal, the example indicates that the cap rate for cashflows to MVIC would be 20% (1 divided by 5) and result in the value of 15. Adding the 3 to the 15 is CLEARLY a double count,  Not surprisingly, I often find valuators who make this mistake getting higher value numbers under the income approach than the market approach due to the double count.

As I stated in my peer-reveiwed Journal of Accountancy article in 2005 and numerous other places, the excess earnings method is no more than a two-stage CCF, with separate rates of return assigned to the left hand or asset side of the accounting equation, which, again MUST be equal to the right hand or equity and long-term debt side.  For an in-depth, classic explanation of this topic, see Pratt’s 4th Edition, Chapter 13 explaining the excess earnings method.

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