Depreciation - To add or not to add?

April 16, 2022

by a searcher in Chicago, IL, USA

Hello Search Funders.

Interested to know what everybodys thoughts are regarding adding or not adding depreciation in when valuing a business?

I see it as a tax break for capital expenditures (which a business requires in order to create revenue). Cap ex is an expense obiously.. so then why is depeciation added into a valuation and multiplied?

Happy to hear peoples opinions and how you all view this when valuing a company.

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Reply by an intermediary
from Boise State University in 800 W Main St, Boise, ID 83702, USA

To determine cash flow for business valuation purposes, the proper approach is to add use net income before tax depreciation amortization and interest and after any normalizing adjustments for non-recurring or discretionary expenses. Then, you could apply either a Capitalization of Earnings (one year) income valuation approach or a DCF (multiple years) income valuation approach. In both cases, you should estimate changes in working capital, long-term debt and capital expenditures. You are looking for the net Benefit Stream which is the cash flow used to determine the business valuation. For the Cap of Earnings Approach, you'll use a capitalization rate (generally "built up" from risk-free rate, industry risk, long term equity risk premium, company specific risk, and size premium). Then you'll divide the Benefit Stream by the Cap Rate and get a value. For DCF, you'll do the same thing except you'll subtract the long-term growth rate from the Cap Rate to get a Discount Rate. Then you'll take the present value of the stream of cash flows and divide it by the Discount Rate. For example, if the Benefit Stream is $100,000 and the Cap Rate is 25%, the value is $400,000 (or 100,000 divided by .25) In this case, the multiple is###-###-#### ,000 x 4.00 = $400,000). A capitalization rate or discount rate can be converted to a multiple and a multiple can be converted back to the cap rate or discount rate. When the word "multiple" is used, it refers to the Market Method of valuation which is based on sold comparable businesses.

Reply by a searcher
from Tufts University in Jersey City, NJ, USA

EBITDA multiples are industry-specific and should already inherently bake in cap ex to at least some degree since you're basing your multiple largely based off of comparable sold businesses, so unless a business is out of line with industry norms you should be fine working off of "multiple of EBITDA".

Understanding cap ex is an important part of doing thorough diligence and assessing an appropriate bid multiple. A business with tons of looming cap ex is not as valuable as one that has everything shiny and new, and you should be factoring that into valuation. If you're bidding in an industry with a typical range of 3-5x EBITDA, analyzing past and expected future cap ex is one of the many things you'll want to look at when deciding where in that range to bid.

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