Small Business Valuation: Free Cash Flow Method

Valuing any business (especially a small business) can be a tricky proposition. A small business valuation is dependent upon an analysis of the company's current and projected performance. Knowing the current and past performance is the easy part of valuing a business - the tough part of a small business valuation is forecasting what the future performance will be.

One popular small business valuation methodology, as outlined in McKinsey & Company's "Valuation: Measuring and Managing the Value of Companies" book, is the Free Cash Flow (FCF) method. The first step in using the free cash flow method for small business valuation is to consider the company's historical performance.

To begin your small business valuation, you will use the company's historical records that you have compiled to determine the company's Earnings Before Income Taxes (EBIT) and Net Operating Profit Less Adjusted Taxes (NOPLAT). These terms may sound complicated, but they simply refer to earnings before (EBIT) and after (NOPLAT) taxes for the company. Depreciation is then added to these numbers to come to a gross cash flow from operations.

The next step in the small business valuation is to calculate the annual investment in net working capital, which can be found by subtracting current operating liabilities from current operating assets. Finding the company's gross investment is the next step, and is defined as the investment in net working capital, plus the capital expenditures and increase in other long-term assets. Once you have determined the above variables, you'll get to the company's free cash flow, which is the gross cash flow from operations minus the gross investment and any investment in goodwill.

The toughest part of using the free cash flow method for a small business valuation method is projecting what these numbers will be for the next ten years. You will need to estimate these values based on the historical data that you have examined, as well as the future expectations for the company. For example, if you plan to buy a small business and feel that you will be increasing revenues by adding new products, or cutting costs by changing locations, your long-term valuation should reflect these new values (and not the historical data). The most important small business valuation consideration is sales growth, as this number is the trigger for all other values.

Using the free cash flow method of small business valuation may be time consuming, but certainly is worthwhile in finding the true value of your business.