The Relationship Of Cash Flow, Risk And Valuations

Theoretically, value is driven from 2 key components… Cash Flow and Risk.

Cash flow is the amount of money a business will generate after all expenses including reinvestment into the business to maintain it. This is often identified at EBITDA (Earnings before interest, taxes, depreciation and amortization) or in other cases as SDE (Seller’s discretionary earnings).

Risk is the uncertainty that the cash flow will continue into the future. Risk can take many forms. Competitive risk arises in industries that have many companies competing for the same customers. Industry risk exists when an industry is becoming obsolete or outmoded. Financial risk can result from the inability of a business to obtain financing or secure terms necessary to continue. There are numerous internal risks such as customer concentration, the lack of a succession plan or the failure to develop a competent management team.

The more risk there is, the less value a company has. Buyers, strategic or financial, are investing in a business for an expected return. The less certain that return the greater the risk of failing to meet financial expectations. Therefore, buyers will reduce the value of the proposed acquisition to offset the perceived risk and improve the likelihood of achieving their financial goal.

Risk rating

Risk rating a company is essentially identifying all its strengths and weaknesses. This is most often done by rating 8-10 different factors such as financial trends, key customers, owner dependence, etc. The greater the risk, the higher the return required by an investor and hence the lower the value of the company. It is worth noting that risk rating is highly subjective and primarily based on the perceptions of the buyer.

The final risk rating of a company translates into a Capitalization Rate, which is then applied to Cash Flow to determine value. For example, let's say a company has $250,000 of Cash Flow and a buyer requires a 25 percent rate of return to balance the risk, then the Capitalization Rate is:

$250,000/25% = $1,000,000 Business Value

If this looks familiar it is because a Capitalization Rate, if inverted, becomes a multiple.

 $250,000 x 4 = $1,000,000 Business Value

 The important takeaway is LOWER RISK, GREATER CERTAINTY, HIGHER VALUE.