What are some common adjustments or assumptions you make when using operating cash flow multiple?

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If you want to compare the value of different companies based on their cash generation, you might use the operating cash flow multiple. This is a ratio that divides the enterprise value of a company by its operating cash flow, which is the cash generated from its core business activities. However, to use this multiple effectively, you need to make some common adjustments or assumptions to account for differences in accounting methods, capital structure, and growth potential. Here are some of the most important ones.

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Bob Honadle

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Jackson Millan

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1 Adjust for non-cash items

Operating cash flow is calculated by adding back non-cash items, such as depreciation and amortization, to the net income. However, not all non-cash items are created equal. Some of them, such as deferred taxes and stock-based compensation, may not reflect the true cash flow of the company. Therefore, you may want to adjust the operating cash flow by subtracting these items, or using a normalized or adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) instead.

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Bob Honadle

I Get Money for SMBs on LinkedIn ? 30-Year Funding Expert ? Business Credit & Cash Flow Mastermind ? Top Cash Flow Voice ? Sales Expert, Coach, and Leadership Mentor ? Fiery Certified Expert
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When analyzing operating cash flow, it's crucial to recognize that not all non-cash items impact liquidity in the same way. For instance, while depreciation and amortization are standard adjustments, deferred taxes can vary significantly based on a company's tax strategy and future obligations. Similarly, stock-based compensation, while non-cash, can dilute shareholder value and affect future cash flows. Thus, using normalized or adjusted EBITDA can provide a clearer picture of operational performance, but it's essential to tailor these adjustments to the specific context of the business to ensure a more accurate assessment of cash-generating capabilities. Understanding these nuances can lead to better investment and operational decisions.

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When utilizing the operating cash flow multiple, common adjustments and assumptions often revolve around factors such as normalized earnings, capital expenditure requirements, working capital fluctuations, and potential non-recurring expenses. These adjustments are crucial for ensuring a more accurate reflection of the company's cash-generating capacity and its ability to sustainably generate returns. Additionally, considerations may also extend to industry-specific dynamics, growth prospects, and macroeconomic trends, which further refine the application of this valuation metric.

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2 Adjust for working capital changes

Working capital is the difference between current assets and current liabilities, and it represents the cash needed to run the business. Changes in working capital can affect the operating cash flow, depending on whether they are positive or negative. Positive changes mean that the company has reduced its working capital, and thus increased its cash flow. Negative changes mean that the company has increased its working capital, and thus decreased its cash flow. Therefore, you may want to adjust the operating cash flow by adding or subtracting the changes in working capital, depending on the direction and magnitude of the change.

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Reghu Achikulathu MSc, MCIOB, MIIQS

Contract & Cost Management | ALEC Engineering and Contracting ||Manager Quantity Surveyor/Commercial Manager @ Shapoorji Pallonji Group | MSc, Quantity Surveying, Commercial Management | NCMA | CMQS
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Changes in working capital, such as fluctuations in accounts receivable, accounts payable, and inventory, should be factored in. Adjusting for these changes ensures that the operating cash flow reflects the cash needed to support ongoing operations, rather than being influenced by temporary variations in working capital.

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3 Adjust for capital expenditures

Capital expenditures are the cash spent on acquiring or maintaining fixed assets, such as property, plant, and equipment. They are essential for the long-term growth and sustainability of the business, but they also reduce the cash available for other purposes. Therefore, you may want to adjust the operating cash flow by subtracting the capital expenditures, or using a free cash flow (FCF) measure instead. FCF is the cash left over after paying for capital expenditures and other non-operating expenses.

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Paul Eder, PhD

I Lead You to New Insights | Strategy Consulting, Artificial Intelligence, & Data Innovation | Author of FIRESTARTERS
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If you spend money on one item, it won't be available for something else. This idea is simple at its core. Yet, without checks and balances, someone may inadvertently allocate resources to multiple simultaneous places.

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4 Adjust for debt and equity

Enterprise value is the sum of the market value of equity and the net debt of the company. Net debt is the difference between the total debt and the cash and cash equivalents of the company. However, different companies may have different capital structures, meaning different proportions of debt and equity in their financing. This can affect the operating cash flow multiple, as debt can reduce the cost of capital and increase the cash flow, while equity can increase the cost of capital and decrease the cash flow. Therefore, you may want to adjust the enterprise value by adding or subtracting the net debt, or using a market value of invested capital (MVIC) measure instead. MVIC is the sum of the market value of equity and the book value of debt.

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5 Adjust for growth rates

Operating cash flow multiple can also vary depending on the growth rates of different companies. Generally, higher growth rates imply higher multiples, as they indicate higher future cash flows and higher returns on investment. However, growth rates are not always constant or predictable, and they may depend on various factors, such as industry trends, competitive advantages, innovation, and customer demand. Therefore, you may want to adjust the operating cash flow multiple by applying a growth factor, or using a discounted cash flow (DCF) model instead. DCF is a valuation method that discounts the future cash flows of the company by a discount rate that reflects the risk and opportunity cost of investing.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Jackson Millan

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When leveraging operating cash flow multiples, it's crucial to consider the industry-specific factors that might influence these calculations. Different sectors exhibit varying capital intensity, operational cycles, and cash flow volatilities, which can significantly affect the applicability and interpretation of these multiples. For instance, technology companies might have lower capital expenditures but higher R&D expenses, impacting their free cash flow differently than manufacturing firms with high CapEx requirements. Additionally, regulatory changes, economic cycles, and market conditions can alter cash flow expectations and should be factored into your analysis.

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What are some common adjustments or assumptions you make when using operating cash flow multiple?

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1 Adjust for non-cash items

2 Adjust for working capital changes

3 Adjust for capital expenditures

4 Adjust for debt and equity

5 Adjust for growth rates

6 Here’s what else to consider

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