Non-operating assets are assets that are not directly involved in the core operations of the business. They can be financial assets, such as cash, marketable securities, or investments in other companies, or non-financial assets, such as land, buildings, or intellectual property. Non-operating assets can increase the value of an asset or project, as they provide additional sources of income or potential upside. To deal with non-operating assets in DCF analysis, you need to do two things: identify them correctly and value them separately.
Identifying non-operating assets correctly requires a careful analysis of the business's balance sheet and income statement. You should look for assets that are not essential for the generation of operating cash flows, that have different growth rates or risk characteristics than the core business, or that have market values that differ significantly from their book values. For example, a manufacturing company may have excess cash that is not needed for working capital or capital expenditures, or a technology company may have patents that are not exploited commercially.
Valuing non-operating assets separately means using different valuation methods for different types of non-operating assets, depending on their nature and availability of market data. For example, you can use the market value or the book value for cash and marketable securities, the net present value (NPV) or the dividend discount model (DDM) for investments in other companies, or the replacement cost or the income approach for non-financial assets. Once you have valued each non-operating asset, you should add them to the value of the operating assets, which is derived from the DCF analysis of the core business.
By following these tips and tricks, you can deal with negative cash flows or non-operating assets in DCF analysis more effectively and accurately. You can also improve your understanding of the drivers and sources of value for any asset or project you are evaluating.
To deal with negative cash flows in DCF analysis, you need to do two things: project them accurately and discount them appropriately. Projecting negative cash flows accurately requires a realistic assessment of the business's performance, growth potential, and cash conversion cycle.
The most effective way to evaluate a negative cash flow situation is to calculate a company's free cash flow. Free cash flow is the money the company has left after paying for capital expenditures (CapEx) and operating expenses.
Having a negative cash flow from assets indicates that you're putting more money into the long-term success of your company than you're actually earning.
We discuss “How is excess cash treated in your DCF valuation?” Excess cash is added to the DCF value arrived at in your DCF valuation exercise. We add excess cash back to the value arrived at using the DCF value because excess cash was not required to run the business and generate the cash flow by definition.
As mentioned before, negative cash flow means that your business is spending more money than it receives. Though negative cash flow is not inherently bad, this financial asymmetry is not sustainable or viable for your business in most cases. Ultimately, your business needs enough money to cover operating expenses.
Discounted Cash Flow (DCF) or income-based valuations calculate a business's value based on its projected cash flow, which is then partially discounted to account for a buyer's risk.
You can operate with negative cash flow so long as you have cash reserves or access to small business funding to continue operations. Startups, which commonly operate at a loss initially, often track their cashflow runway, meaning how long they can last with negative cash flow until they run out of money.
The idea behind NPV is to project all of the future cash inflows and outflows associated with an investment, discount all those future cash flows to the present day, and then add them together. The resulting number after adding all the positive and negative cash flows together is the investment's NPV.
The most common types of activities in this section are purchasing or disposing of property, plant, and equipment (PP&E) and acquiring another company. When a company purchases a piece of PP&E, that is a negative cash flow. This is considered positive for the company though.
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