The Working Capital Series: Valuation

by: The Private Equiteer

There are various methods used to value investees, but private equiteers tend to focus on earnings multiple valuations and discounted cash flow [DCF] valuations. Working capital affects these valuation methodologies in the following two ways:

  1. fcfThe earnings or cash flow figures may be influenced by changes in working capital (delta) across periods
  2. The net debt (specifically cash) position may be affected by the operational working capital requirements of the business

In a discounted cash flow [DCF] valuation, working capital is analysed to help calculate free cash flow [FCF] for each period (see right for equation). These free cash flows are discounted and summed to arrive at a valuation. This is simple textbook stuff, so I want to concentrate on working capital considerations in earnings multiple valuations for the remainder of this post.

Unlike a DCF, an earnings multiple valuation is based on maintainable earnings; that is, the level of earnings that can be maintained indefinitely. If all else is equal, working capital (from an analyst’s point of view, i.e. ex-cash) remains the same across periods and so there is no cash surplus or shortfall between periods. And so, there should be no working capital offset in the maintainable earnings calculation.

You may be thinking, “but we don’t expect earnings to stay flat and so there will be working capital consequences and since different businesses are affected differently as they grow, we need to consider it somewhere.” Well, you need to account for this via the applied price multiple. What does that mean? If the firm’s working capital profile spins off a lot of cash, investors will be willing to pay a higher multiple, and vice versa.

Remember, even though growth may increase the theoretical cash shortfall, growth also generates greater earnings and greater value.

So, the verdict on point 1 (from above) is that the earnings figure used in an earnings multiple valuation should not be adjusted for working capital delta because it is a maintainable estimate. However, you may account for a firm’s working capital profile in the multiple if it is abnormal or if the multiple is already assuming high growth.

The one exception is where you know of a material change to working capital that will create a material difference between current and future earnings figures.

evOnto point 2 (net debt position): working capital may affect the enterprise value [EV] because not all cash at bank can be used to repay debt. You may remember from the basic EV calculation that EV equals equity value plus total debt less cash; the idea being that cash can pay down debt. However, you shouldn’t simply assume that all cash at bank is excess cash to pay down debt.

There are numerous examples where cash is needed to support a firm’s operations and hence, is part of its earnings multiple valuation. The simpler way to think about it is, how much cash can I remove from the business without causing disruption? Since an earnings multiple valuation is theoretically based on future earnings, I personally believe that enough cash should be left in the business to support working capital gyrations for the first year.

This doesn’t mean that if cash momentarily dips $2m that the vendor should leave $2m for the new investor. What it does mean is that enough cash should be left to pay the finance / opportunity costs of supporting that $2m working capital requirement for the first year. I think this is fair since you’re valuing the business on future earnings and it will take a momentary investment of $2m to create those earnings.

There are also other scenarios in which vendors should leave cash in the business. In retail businesses for example, if all cash is taken from the tills, the business won’t operate properly. Ipso facto, the money required to adequately fill the tills is operational and included in the earnings multiple valuation (and shouldn’t be considered excess cash). It may be difficult to agree on a number in this case, but theoretically I believe the reasoning to be sound.

So, the verdict on point 2 is that not all cash at bank should be thought of as excess cash in a earnings multiple valuation. Any cash required for the operations of the business and / or to subsidise the opportunity costs of cash shortfalls should be left in the business. In an EV calculation, this cash should not be used to reduce debt to arrive at a net debt figure.

This is a long post, but I hope it helps to form your own views on working capital and valuations. It should be a simple topic, but theories seem to change daily; depending which side you’re on in today’s latest deal. If you think I’ve left something out or if you have alternative views, please let me know.