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Business valuation is typically based on three major methods: the income approach, the cost approach and the market (comparable sales) approach. Among the income approaches is the discounted cash flow methodology – calculating the net present value (“NPV”) of future cash flows for an enterprise. As an alternative to the more abbreviated income capitalization approach, this methodology is more relevant where future operating conditions and cash flows are variable – or not projected to be materially consistent with current performance levels. This tool illustrates how cash flow, growth rates and capital assumptions impact valuation levels.
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Definitions
- Expected annual growth rate
- The expected annual growth rate for the business is applied to year 5 and beyond to determine future operating cash flows.
- Weighted average cost of capital (WACC)
- The weighted average cost of capital represents the interest cost and investment return lenders and investors require to provide capital for the business. The typical weighted average cost of capital ranges between 12% to 25%.
- NPV Value of the business
- The net present value of all of future operating cash flows is discounted to present value dollars determined by the Weighted Average Cost of Capital (WACC).
- Operating profit
- The net operating profit of an enterprise is often characterized as EBITDAR – representing earnings (or net income) before interest, taxes (income), depreciation, amortization and rent. EBITDAR generally represents cash flow available to support the capital structure (debt and equity) of an enterprise.
- Provision for Management / Other
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In determining the appropriate level of future operating cash flow, certain adjustments may be required to reflect normalized amounts. For example, lenders and investors customarily require a provision for management costs equating to not less than 5% of operating revenue. Other non-operating or non-recurring revenue and expense items may be included in the reported EBITDAR. The Provision for Management / Other allows for the adjustment of reported EBITDAR to determine the more appropriate and normalized income level to be projected.
- Provision for Capital Expenditures
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The Provision for Capital Expenditures represents an EBITDAR adjustment to compensate for material deferred maintenance items or other projected capital needs to sustain property conditions required for continuing operations. For example, should a property require a new roof, a provision equivalent to funding this capital need may be considered. As a matter of routine underwriting practices, lenders and investors typically assume a recurring provision for capital needs. A customary annual reserve is not less than $300 per bed/unit – yet can vary widely depending upon the assessed condition of the property and its content.
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