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Is cash flow the best way to value a business?
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3 Answers
The best and worst answer is "it depends" on the business and its condition/situation. Cash flow is one of the 3 primary financial indicators. Without knowing specifics, it may be no more important than what can be determined from the balance sheet (cash, assets including cash, property, AR and liabilities such as debt, AP, other financial obligations, etc.) or P&L (how much the business generates in revenue and profit, cost structure, EBITDA or Operating Profit, other financing gains and losses month to month. I would say cash flow is like looking at "vital" signs on a patient, and is more critical if a business is struggling or in financial trouble. There are many ratios that are commonly used to determine the financial health and value of a business and can be grouped into 5 buckets - Liquidity, Leverage, Coverage, Profitability, Activity (how and what a company gets for a return on its assets). Multiples of revenue or EBITDA or commonly used.
This is a bit of an opinion answer, but in general, it depends on the business/industry. A few businesses I've worked in (clothing manufacturing, consulting/staffing) are very cash flow dependent. As such, valuing a business on cash flow is very prudent in this space. In clothing, you have to product and/or buy your product well before you sell it. In staffing, you have to pay your people before you get paid. Whereas a business doing software development or SaaS is likely much less cash flow dependent. Once you build the software or service, the business only spends as much cash as desired (support, marketing, improvements, etc.) So, I would suggest first deteriming in cash flow is important for the business/industry and then decide if it is a good valuation point.
To take Ken's point a little further, the valuation of a business based solely on cashflow could possibly over value or under value the firm based on serveral factors including its place in the business life cycle, industry, timing of the cash flows, assets owned, etc. The value of any asset including a business is the present value of its future cashflows. If cashflows are expected to remain steady for the foreseeable future then this might be the right approach, if not then the value estimate may not be accurate. Valuation professionals are required to examine three approaches to value, the income (cash flow), the asset or cost, and the market approach. The income approach discounts or capitalizes the company's cash flows using rates that are observable in the market place. The asset approach values the individual assets and subtracts the liabilities. The market approach compares the company to transactions or publicly traded guideline companies or groups of companies. It is left to the appraiser to determine the appropriate weighting for each approach in the reconciliation of value.
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