There frequently seems to be confusion amongst business brokers, business buyers, and business sellers about which measurement of cash flow to use when valuing a business. This, in fact, can be a very tricky subject and the answer depends on the valuation approach and assumptions being utilized.
It's important to use the measurement of cash flow that is consistent with the assumptions of a particular approach to value.
For example, when using a Discounted Cash Flow (DCF) approach to value, you project the likely future cash flow of the business and then discount it back to the present at a rate that is commensurate with the risk of the investment. The theory is that the value of a business should be equal to the present value of all future cash flow. But what does "cash flow" mean? Is it Net Income, Earnings Before Interest Taxes Depreciation and Amortization (EBITDA), Seller Discretionary Cash Flow, or some other measurement of cash flow? Unless adjusting other assumptions, a Discounted Cash Flow approach should use Operating Free Cash Flow (OFCF), which is EBITDA minus taxes and capital expenditures and adjusted for changes in net working capital (if the net working capital from the beginning of the year to the end of the year increases, then that would result in a decrease in OFCF). Discount rates are usually developed based on OFCF as the type of cash flow being used. If, instead, another type of cash flow were used but the discount rate continues to be based on OFCF it could result in a materially lower or higher value estimate.
Similarly, I often see people mis-labeling Seller Discretionary Cash Flow, which is EBITDA plus the expensed compensation of one owner, as "adjusted EBITDA", which would be higher than EBITDA. The problem with this is that if using a market comparable approach to value where multiples of EBITDA were created from sold comparables based on lower actual EBITDA after paying an owner's wage, rather than Seller Discretionary Cash Flow, the multiples will be higher. If those multiples are then applied to Seller Discretionary Cash Flow of the target company (mis-labeled as adjusted EBITDA) it will over-value the business.
It's important to understand what financial measurements are used in each valuation approach, the correct methodology, and other underlying assumptions. For people who don't have expertise in business valuation there is ample opportunity to make a mistake. Whether you are buying or selling a business, it is wise to hire someone with expertise to help you navigate this surprising complex and nuanced subject.
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