When valuing a private operating company, an appraiser is likely to use an income approach, either as the main valuation method or in conjunction with another method. Whether the appraiser capitalizes cash flows in a capitalized cash flow (“CCF”) model or uses forecasts of future cash flows in a discounted cash flow (“DCF”) model, they have incorporated both explicit and implicit assumptions into the cash flows used in their model.
There are numerous assumptions appraisers must make when building a cash flow based valuation model. I have reviewed hundreds of valuation models and reports during my career in public accounting. In some models I have reviewed, it appears that certain assumptions are made perfunctorily. While the intention of the appraiser may not be to mislead users of the valuation, the user (and sometimes the appraiser) may not be aware of the potential magnitude a cursory selection of an assumption may have on the value of a company.
One set of assumptions that must be made in a cash flow forecast is the forecast of normalized depreciation, amortization and capital expenditures (“capex”). These assumptions appear in the discrete historical periods of the cash flows analyzed for a CCF model, and in both the forecasted discrete periods and terminal value of a DCF model.
The goal of these assumptions is to “normalize” capital expenditures, depreciation and amortization to levels that support the company’s forecast future performance. There are some common errors to watch for regarding these assumptions in a business valuation.
The first thing to know is that capital expenditures always come before depreciation. A company cannot depreciate assets it has not yet purchased! Therefore, if an appraiser is using historical company information to make a simplified normalization adjustment, they should be adjusting depreciation to forecasted capex, rather than the reverse. However, this assumption may be an inaccurate one if the appraiser has not analyzed the historical capital expenditures thoroughly for average useful lives, existence of long-lived assets, and the depreciation methods used. This is also the reason that depreciation should not exceed capital expenditures in the cash flow being capitalized in a CCF or in the terminal year of a DCF.
While amortization is often presented on the same expense line as depreciation in a company’s income statement, “depreciation and amortization”, it should typically be treated differently by the appraiser. Amortization is the term used for the “depreciation” of intangible assets, which are usually created by the acquisition of another company. While fixed assets are systematically replaced in an ongoing, growing business, intangible assets typically are not. Further, the current values of intangible assets are inherently included in the total company value being determined by the appraisal, so subtracting amortization charges based on historical intangible asset values is incorrect. Therefore, amortization should be excluded from the cash flow forecast, and consideration should be given to separately valuing any expected future tax benefit it generates and adding this to the enterprise value.
An appraiser may make a simplifying normalization assumption that sets depreciation and capex to be equal in the terminal period forecasted cash flows. This assumption is typically only appropriate in zero-growth/inflation scenarios. If growth is projected in the cash flow forecast, capex should typically exceed depreciation in the terminal period.
If the company owns long-lived assets, such as buildings, it may not be appropriate for the depreciation on these assets to be forecast into perpetuity. Look for an adjustment to the depreciation forecast for these assets and a separate valuation of (or at least a discussion of) the tax benefit overhang.
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