Focus on Free Cash Flow
When analyzing and determining values, there is a tendency to use shortcuts or recommended calculations. For example, Cash Flow Return on Investment is advocated by some while others like to measure value by calculating EBITDA - Earnings Before Interest Taxes Depreciation Amortization. The problem with these approaches is that they tend to bypass "free" cash flows. And free cash flows are the source of valuations.
Think of free cash flow as the amount of cash you can draw out of your organization after you've paid everything off. This is the amount you want to use for determining value. If you were to use EBITDA, you would falsely assume that the asset base will be systematically capitalized over time with no future additional reinvestments into assets. How long can your organization generate future revenues with a declining asset base? Consequently, you need to be careful about fashionable ways in arriving at valuations. Get back to Cash Flows. If you want to rely on the Income Statement, than add back non-cash items such as depreciation and subtract out future working capital requirements and future capital investments. Don't shortcut your analysis; go back to how you arrive at cash flows.
Written by: Matt H. Evans, CPA, CMA, CFM | Email: email@example.com | Phone: 1-877-807-8756