My entire career has involved financial analysis in various applications: bank lending, business analysis, securities analysis, and business valuation. Perhaps the biggest lesson I have learned from my training and experience is:
“If you do not understand the cash flows and risks, you can’t be confident of your conclusion.”
To understand, we need to know:
The amount(s) and timing of the investment (cash in)
The amount(s) and timing of the benefit (cash out)
Based on these, the expected rate of return
The risks
The rate of return required to compensate for the risks
Discounted (or capitalized) cash flow analysis answers the questions. It tells us the cash-on-cash (benefit compared to investment) rate of return. Risk analysis tells us the required rate of return, again on a cash-on-cash basis.
What do all of the following issues (some resolved, some not) have in common?
Tax-effecting “S” corporation earnings
Deduction for embedded capital gains tax liability
Adjusting cash flow to control level
Adjusting cash flow to exclude extraordinary items
“Packaging adjustments” to compare asset sale with stock sale values
Handling non-operating assets and liabilities
Whether a controlling interest bears a lack of marketability discount
WACC issues (the proper debt/equity ratio, iterating)
Using a justification of purchase test
I can think of others, but they all relate to the same issue: the relevance of particular cash flows to a business valuation. As appraisers, we are on strong, defensible ground if we can support the relevance of a particular cash flow. For example, if a client is selling the assets of his or her business, we might use the Direct Market Data Method to value them. That will tell us the asset sale proceeds. We then have to add retained assets and deduct retained liabilities to determine what the client will end up with – the value of his or her equity. There may be practical difficulties (Which assets are going to be sold or retained?), but the theory is sound.
In a similar vein, if we have a good basis for projecting the future debt level of a business (e.g., the owner plans to pay off all existing debt as scheduled, and our forecast indicates that the business can easily do this), then there is no need – and it would be wrong – to use WACC with a constant debt/equity ratio, since that ratio will eventually reach zero.
The “S” corporation tax-effecting issue is another example. There are many widely accepted, published models that analyze the benefit of “S” corporation status in terms of the difference between corporate and personal tax rates and other factors. We are on strong theoretical and practical ground in using them, because we know the cash flows and the risks. In sports vernacular, “This is OUR house!” In this case, however, we run into conflict with court cases (all based on situations with unique facts and circumstances) from which the Service and Tax Court draw general inferences that conflict with financial theory and practice. This is THEIR house! We may have to accede to these precedents.
In the end, it all comes down to this when you are analyzing a valuation situation:
“If you do not understand the cash flows and risks, you can’t be confident of your conclusion.”