Dumb Question: EV = Cash Flow/(Discount rate - growth rate) in practice
Burner account because this is a dumb question.
I'm an intern at a local PE shop and was recently tasked with screening companies against search parameters. Many of the websites I'm using to screen give an asking price and cash flow. So let's use a theoretical company A where cash flow is $1,000 and asking price is $2,100. My first thought when seeing companies like this is that an asking price that's 2.1x cash flow seemed like it wasn't normal. So I thought of my BIWS training where EV = Cash Flow/(Discount rate - growth rate). Can I use this formula to solve for implied growth rate?
So lets say company A has a WACC of 15%, cash flow is $1,000, and asking price is $2,100. To solve for implied growth rate, the formula would be: Discount rate - (cash flow/EV). However, this gives an implied growth rate of -33%. Why does this not make sense?
I hope your real account has a good name, because the burner name is pretty great.
Yes, that's the formula when cash flows are steady / not growing. You're likely seeing this because normalized FCF is much, much lower than $1,000.
Why doesn't it make sense? Given your parameters, Year 1 CF contributes almost 50% of your asking price. So your asking price is too low if you want to see positive growth rate
Just using sites like BuyBizSell shows companies that have asking prices that only 2x cash flow. I'm assuming they just use EBITDA for cash flow, but I wouldn't think that the difference is that much. There is a midwest company I just found as an example that has cash flow of $1 mm and the asking price is $3.5 mm. At a discount rate of 15%, thats an implied growth rate of -13.6%.
Bizbuysell advertised cash flow is always too high. In reality it excludes the salary of the owner, tax, capex, and probably whatever the seller thinks he can get away with. It might be half of what is posted.
Also, the discount rate should be more like 30-40% on such a small company.
Using those figures, $2.5mm valuation on $1mm "cash flow" is much less of a steal than it appears.
That makes much more sense. Thanks.
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