Myth #4 - When calculating sustainable cash flow, sophisticated purchasers do not factor in future expected cash flows which are routinely seen as “potential” or “blue sky”. No One Pays for Potential.
Oliver Wendell Holmes defined it clearly and briefly….
"All values are anticipations of the future."
There are a number of going-concern valuation approaches, such as capitalization of after-tax maintainable earnings. It has been our experience that when dealing with small businesses, many purchasers do factor in future expected cash flows. We have heard the expression “I will not pay for potential” a thousand times. When determining the sustainable cash flow of the business many prospective purchasers will argue that the sustainable cash flow should be an average of the company’s last five years of actual cash flow – arguing that the 5-year average represents the true sustainable cash flow of the business. The logic is usually that the business over 5 years has been through a typical business cycle and that this average incorporates the good and bad years.
We however have found that purchasers do calculate future expected cash flows and that this factor may be heavily weighted in their offer to purchase:
- If the business has been trending positively over the past few years, the previous three may not be relevant as the business may have been preparing itself for future growth. Some examples could be adding additional salespeople and the development of a formal marketing plan. These increases in expenses may not always result in an immediate increase in profitability.
- Many purchasers will argue they will not pay for anticipated growth or “potential” or “blue sky” even if the business sales and profits have been trending positive for more than a couple of years. However, when sales and profitability are in decline, some purchasers will focus only on the last few years of decline and ignore the previous profitable years when calculating the sustainable cash flow of the business. This one-way approach doesn’t work in the real world and rarely are these buyers successful in their acquisition.
Our experience has been that those small business purchasers who are entrepreneurial and have a bias towards making an acquisition will justify the purchase price using a variety of criteria– one of the most important is the future expectations of the business under the purchaser’s management.
Valuation is not just a formalistic approach based on historical economic information. To a willing buyer, potential becomes an opportunity, and perceived opportunity becomes reality.