Cashflow. Cashflow. Cashflow. In the midst of COVID19, cashflow is everything. While some digital and eCommerce businesses are ramping-up, the vast majority are seeing cash inflows (+) turn to outflows (-) and bleeding red.
It is estimated that in Canada, for example, it is estimated that COVID19 could force 40% of SMBs (Small and Medium Businesses) to shut their doors permanently. The worst part is the uncertainty of not knowing when it will end and what the outlook will be when the economy ‘reopens.’ Suffice to say that most entrepreneurs and small business owners are wondering what to do in the short, medium, and long-term.
The goal of this post will not be to find ways to boost cashflow but instead to look at how (Free Cashflows) are used to generate an Enterprise Valuation. The problem with a year like 2020 is that we know that (in most cases), revenue will be down, EBITDA will probably be negative, and many SMBs will be required to either refinance or raise capital to survive.
One has to believe, however, that good businesses will come out of this crisis in a position to make it all back and then some. In this light, we need to know how to measure the value of future cashflows and how to structure that information into an Enterprise Value in today’s terms.
Present Value, Discount Rates, and Free Cashflows
The time value of money is a central tenet in the Finance world. Simply put, $1 of profit (EBIT = Earnings Before Interest and Tax) is not equivalent in today’s terms as to what it would be in 2025 for example.
EBIT is the chief metric for profitability, as it can be used to assess the performance of a business for finance purposes. Earnings before Interest and Tax (or EBITDA = Earnings before Interest, Tax, Depreciation / Amortization) assesses a business’s performance before any accounting is factored in.
Generally, this is Revenue – COGS (Cost of Goods Sold) in order to see Gross Margin. Once you know Gross Margin, you subtract SG&A (Sales expenses, General expenses, and Admin expenses) along with any other expenses. Here you have EBIT.
Now imagine EBIT over a continuum of time. For example, let’s say that you earn:
>$100K in EBIT in 2020
>$200K in EBIT in 2021
>$300K in EBIT in 2022
On the surface, you would say that EBIT has tripled 3X between 2020 and 2022. But the numbers in 2021, 2022 and beyond need to take into account the time value of money.
Simply put, when you factor in inflation (~2%) and the tradeoff risks of the value of $1 in 2020 versus $1 in 2022, it makes sense that $1 in 2022 will be worth less. How much less depends on the discount rate that you select.
In simple terms, if your discount rate is 10%, then $1 in EBIT today will be worth $0.91 in 2021, and $0.83 in 2022. Looking at the formula below and referencing the numbers above:
>$100K in EBIT in 2020 = $100K Present Value (PV)
>$200K in EBIT in 2021 = $200K / (1+0.10)^1 = $182K PV
>$300K in EBIT in 2022 = $300K / (1+0.10)^2 = $248K PV
Therefore, the Present Value* of these EBIT Cashflows would be $530K (100K + $182K + $248K) at a 10% Discount Rate.
*you could argue that the PV would apply in 2020 as well. More on that in the example below.
How is the Discount Rate calculated?
The technical calculation is shown below. It is all based around the idea of the risk-free rate of return (generally the 10 Year Government Bond Yield in a given country, around 2-3%), plus the additional risk related to the specific market factors of a given enterprise. The bigger and more profitable an enterprise is, the lower the discount rate.
The idea behind this entire formula is to gain an understanding of the risk associated with expected earnings for any given business.
A 10% Discount Rate would be seen as a reasonable discount rate for SMBs with some earnings history and revenues. This is not advice or a formula to be applied specifically, it is just meant to help put some initial parameters around the risk and potential discount rate for a SMB, which will be illustrated further down.
Before we get into more specific Enterprise Valuation (EV) calculations, let’s take a look at the definition of Free Cashflows, something that investors are looking for over and above anything else.
Taking into account what we said earlier about EBIT, we must subtract (-) any CAPEX (capital expenditures) and Δ Working Capital, and add (+) back in Depreciation to have a measure on Free Cashflows (FCF) for the business. Once we have a view on FCF for several periods into the future (either Quarters or Years), we can start putting together estimates on valuation based on the applied Discount Rate.
Discounted Cashflows (DCF) and Enterprise Value
Keep in mind that the below example is only an illustration of the concepts and is designed to help educate and inform around strategy; it is not meant to be taken as advice or at face value.
Let’s take a look at a basic Excel model for a business with expected future EBIT over a time horizon of 5 years. First off, here is a list of the assumptions:
>the business had strong revenues in previous years (ie. not a startup)
>the Discount Rate is 10% based on a reasonable estimate of the risk going forward. That Discount Rate is applied to 2020 EBIT given the uncertainty this year
>No considerations for anything related to fixed costs (ie. Capex) or leases were made in the model; this is likely not realistic for most businesses unless they are 100% online
>the business is projected to be down 50% in Revenues in 2020, recover to 2019 levels in 2021, see big growth in 2022, and then grow at modest levels (5% per year) indefinitely
Here is the EBIT Calculations from the Excel model:*
Here are the EV (Enterprise Value) Calculations from the Excel Model:*
*the accuracy from this model is not verified and serves only as an illustration.
The main point is to show that despite the fact the business has, in this case, seen its revenues and profitability plummet, as long as the company maintains its ability to generate revenue and profits in the mid to long-term then it will continue to maintain some value.
The Enterprise Value (EV) calculation ($4,317,996) is only illustrative. Valuation is a tricky exercise because it depends on factors such as market cycle (Recessions vs. Expansion), Comps. (comparison to other firms), and internal factors such as team and strategy. But in this case, you can see that with the assumptions made, the business is still projected to be valuable on a long-term basis.
This type of thinking – rooted around the Discounted Cashflow (DCF) model – is helpful in times like this when businesses lose a lot of their revenues/profits in a given year but expect a recovery on the horizon over the mid-term. Naturally, any potential financier will apply their own thinking and methodology to the situation. Additionally, small changes in assumptions can have big impacts on the model. That’s why this is meant to be an illustration of the concept, not a detailed look at how to do DCF Valuations. This a very complex area of Finance, and above is only a rudimentary view of that.