Chapter 11
Benefit streams

To illustrate the finer points of business valuation, this and the next two chapters will examine the three principal elements of a valuation. You start with a benefit stream (e.g. cash flow). Divide that number by a required rate of return (e.g. capitalization rate) and then apply a discount (e.g. discount for the lack of control if a minority interest) to arrive at a final value.
We will use the following example throughout: A 5 percent interest in a midsize trucking company.

In this chapter, we tackle benefit streams (1). What are benefit streams? They are the things you work so hard to create – your paycheck, your net profit, your cash flow, revenue and anything else that you consider to be a benefit of working in and owning your company. But what benefit stream best estimates what the buyer can expect to be his future economic income stream?

The valuation analyst’s task is to determine which benefit stream best measures your company’s performance. Usually, the benefit stream used in valuation is a measure of cash flow or net income. Common benefit streams include:

• Operating cash flow
• Discretionary cash flow
• Gross profit
• Net profit
• Debt-free cash flow
• Revenue
• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)

Selecting a stream
The estimated future benefit stream is determined based on the following criteria:

• The type of benefits that will be used as a measurement of economic income.
• Whether historical or projected economic income is used to estimate future benefits.
• The method used to calculate the estimated future benefits.

The type of benefits used depends on the nature of the interest that is being valued. The future benefit stream may represent a controlling or a non-controlling interest. The nature of the interest and the benefit stream must relate.

Suppose you own a 5 percent interest in the company. Net profit may not be a good benefit stream for valuation because the owner of such a small stake has no influence over profit. The purpose of the valuation also affects the type of benefit stream that is used. And in some cases, the benefit stream is defined upfront by the parties seeking the valuation. For example, when valuing a business based on a buy/sell agreement, the benefit stream may be defined in the agreement -- average revenue over a two-year period, for example.

Actual or projected?
Should the analyst’s estimate be based on historical performance or projected economic income? This can be a difficult decision. The valuation analyst must consider whether historical economic income or management’s projections are more appropriate for estimating the future benefits of the company.

The analyst must consider the purpose of the valuation, the history of the company and the state of the industry and the economy. The purpose of the valuation may help determine whether historical or projected economic income is appropriate.

The general guidelines for using historical economic income to estimate future benefits are:

• The purpose of the valuation is for tax or divorce because historical economic income is based on fact and thus considered more reliable than projected economic income.
• Historical economic income is indicative of expected future benefits based on the stability and trend of historical earnings.
• The company is mature.
• Historical operations are a good proxy for the future.
• The future benefit stream is linear or expected to remain constant.

The general guidelines for using projected economic income to estimate future benefits are:

• The purpose for the valuation is non-tax, ESOPs, or some litigation valuations because projected economic income may be considered more representative of the future.
• Projections are available and are considered indicative of the expected future benefits.
• There is a lack of reliable historical data.
• The company is an emerging business.
• The company is in its start-up development stage.
• The future benefit stream is non-linear or is expected to grow or decline at a variable rate.

Averaging
Once you decide which benefit stream is most appropriate, the analyst turns to reaching the actual number. Usually 5

years of data are used for either historical or projected performance. The method used to calculate the estimated benefit stream depends on whether the anticipated future benefit stream is linear or non-linear. A linear benefit stream means that the estimated future benefits are expected to remain the same or grow or decline at a constant rate. Historical economic income is typically used when estimating a linear benefit stream.

The two most common methods that are employed to estimate future benefits based on historical economic income are the unweighted average method and the weighted average method. A non-linear benefit stream implies that the estimated future benefits are predicted to grow or decline at a variable rate. Projected economic income is often used when the benefit stream is expected to be non-linear. Two common methods for estimating future benefits based on projected economic income are projected cash flows and projected earnings.

The best benefit stream
The types of benefit streams can be divided into two main categories: cash flows and earnings. Cash flow benefit streams usually include operating cash flow, after-tax cash flow and discretionary cash flow. Earnings streams include net income and earnings before interest and taxes (EBIT). Earnings before interest, taxes, depreciation and amortization (EBITDA) is a combination of the two benefit streams.

In general, EBITDA appears to be the preferable benefit stream for valuations of trucking companies. Benefit streams based solely on earnings – i.e., net income – do not take into account changes in cash flow. Net income is a result of revenues less expenses. Accountants can do magical things with net income – especially when you are purchasing new equipment. Likewise, net income does not do a good job of capturing the true economic income of a trucking company that is growing (adding equipment) or suffering (slow collections). A cash flow benefit stream captures these items more effectively.

One problem with EBITDA is that it does not do a good job with receivables. Unless your operation is very small, your company is on the accrual basis of accounting – meaning you recognize income from a haul when that haul is complete rather than when the cash is collected. That means net income provides no indication of your cash situation, so troubles in collecting accounts receivable would not be reflected in an accrual-based income statement. Your revenues would reflect the services your company provided to the shipper but would not reveal the fact that payments had not been received from these services, thus resulting in an overstated value of the company. To take this flaw into account, analysts often use a form of EBITDA and add to it the changes in working capital, which capture the effect of collections in your company.

EBITDA eliminates the effects that depreciation and amortization have on your bottom-line profitability. Depreciation can be a significant annual expense for trucking companies due to the large amounts of expensive equipment necessary to operate a trucking company. However, depreciation expense does not actually cost the company any cash. It simply reduces the profits of the company over time. This is known as a non-cash expenditure. Adding depreciation and the similar expense of amortization back to the profits of the company provides a more realistic look at the income stream generated by the company.
Another common cash flow measure that is added to EBITDA is planned capital expenditures. As you trade equipment or plan to replace equipment, these cash outlays must be considered.

Adjusting the benefit stream
Picking the correct benefit stream is vital to a business valuation. Just as important is making the appropriate normalizing adjustments to ensure that the benefit stream reflects true economic income. A normalizing adjustment seeks to eliminate unusual items or situations in financial statements.

For example, the owners’ compensation in most closely held companies is often much higher than industry standards because owners often pay themselves company profits in the form of salary. A valuation analyst would make a normalizing adjustment to reduce owners’ compensation to a level that is more comparable with the industry and job description. This adjustment would increase the profits of the company, resulting in a larger benefit stream.

Another typical adjustment reflects anticipated capital expenditures. Suppose you decide to add 10 new trucks to your fleet, resulting in a change in the cash balance. It’s unlikely that you will pay the entire balance of your purchase at once, but you probably will have to pay some cash for the down payment. This is an example of a capital expenditure. It is important for a valuation analyst to consider such future expenditures in the valuation because these expenditures will have an effect on the future cash flows of the company.

It’s useful to know early on the benefit stream that likely will be used for valuation. If you are grooming your business for a sale and want to maximize your return, you will want to focus your financial decisions on areas that will increase this stream.