At the end of the third bridge, a business knows its cash. It can separate what it spends to keep its assets running from what it spends to grow. Its working capital, balance sheet, tax and perimeter are stated, and its forecast reproduces its own history. The figure that sums all of that up is free cash flow to the firm: NOPAT, plus depreciation and amortization, less capital spending, less the change in working capital.
The figure has two names. Free cash flow to the firm says who it belongs to, which is every provider of capital, before any of them is paid. Unlevered free cash flow, the name used in quality-of-earnings reports and lender packs, says what it leaves out, which is the effect of borrowing. The next anchor, free cash flow to equity, is the same figure after the lenders have been paid, which is why it is also called levered.
Three tests and the numbers they fix
An enterprise buyer is asked to believe that this business turns its earnings into cash every year, after keeping its assets running, carrying the working capital it needs and paying its own taxes, and that the amount can be forecast because the business has planned its years and hit the plans.
The framework tests that claim at three strengths, and each test fixes numbers the valuation uses. The capital spending, working capital, cash and tax records show that the cash exists, and they fix the base-year cash flow. Whether it will keep coming rests on the asset register, the clean balance sheet, the debt-like schedule and the perimeter, which fix the maintenance deduction and what is being sold. Trust in the forecast comes from the budget record, the back-tested model and the reinvestment register, and those fix the growth rate, the reinvestment rate, the return on new capital and the year growth settles. Any part of the claim with no record behind it is dropped, and no number goes into the valuation unless the records account for it.
Whose value
The standard is fair market value, the price between a willing buyer and a willing seller, neither compelled and both informed, which is the standard an enterprise buyer's modelling team prices on. Where a named strategic acquirer exists, investment value to that acquirer is computed beside it, with every synergy attributed to the buyer, so the owner knows which part of a strategic's price is theirs to claim. Where the number is going to a court or a dispute, the jurisdiction's statutory standard is computed separately.
The business is valued as a going concern inside the perimeter of sale. Orderly liquidation value, what the assets would fetch sold over a year less the costs of selling and winding down, is computed beside it, and the premise switches to liquidation only where the business's no-growth value falls below that figure. The conclusion is at the control level, because the unit being sold is the whole enterprise. The adjustment for control is nil, because the owner's excess pay and non-market arrangements came out of the cash flows on the earlier bridges. Any conclusion issued from the file is prepared to the applicable appraisal standard.
The cash flows govern
This is the first anchor where the discounted cash flow is the valuation itself. On earlier anchors it served as a check. The cash flow is free cash flow to the firm, year by year from the integrated forecast, with a terminal value at the year growth settles. Because that cash flow belongs to everyone with capital in the business, it is discounted at the weighted cost of all of that capital, and no equity cash flow or cost of equity appears anywhere in the enterprise valuation. The value of the equity comes afterwards, in one step.
From the enterprise to the equity
Illustrative. The enterprise value belongs to everyone with capital in the business. The owners' share is what is left after the lenders and every debt-like claim, plus any cash the business holds beyond what it needs to operate.
Take enterprise value, subtract the debt and every debt-like item on the schedule at the amounts a buyer will deduct, and add cash above the operating minimum the weekly forecast shows, and what remains is the value of the equity. In the illustration, an enterprise worth $8.5 million with $1.2 million of debt, $380,000 of debt-like items and $250,000 of cash above the minimum leaves equity of about $7.2 million.
The EBITDA multiple of comparable transactions is kept and labelled as pricing, with the drivers that explain it stated beside it: growth, margin, cash conversion, capital intensity, concentration and the share of recurring revenue. It is computed beside the DCF, the gap between them is explained line by line, and the DCF is never adjusted to close it.
The rate
The marginal investor at this anchor is diversified: a fund, a strategic acquirer or an institution that holds this business as one of many and prices only the risk it cannot diversify away. Its required return is built from the market.
A rate built from the market
Illustrative. The comparables' beta is unlevered, relevered to the structure buyers use for a business of this size, and turned into a cost of equity; debt is priced at today's rate after tax; the two are weighted by the target structure. Nothing is added for size or for the business's particular risks, which sit in the cash flows and the scenarios.
The cost of equity starts from the beta of a stated set of public comparables in the sector, unlevered at their own debt and tax rates and relevered to the capital structure buyers use for a business of this size. The cost of debt is what a lender would charge this business at that structure today, after tax, taken from current term sheets. The owner's old loans say nothing about it. Every component is shown with its source and date. In the illustration, a 5.5 percent risk-free rate, a 6 percent equity risk premium and a sector beta of 1.1 relevered to a quarter debt give a cost of equity of 13.75 percent, and weighted with debt at 6.75 percent after tax they give a 12 percent cost of capital, the rate the other illustrations in this essay use.
Nothing is added for size, because size is already in the comparables and in the scenarios. No company-specific premium is added either, and no risk the scenarios carry is put in the rate as well. Owner dependence came out of the cash flow at the previous anchor. Customer concentration is priced in the scenarios. Capital spending and working capital risk sit in the cash flows through the maintenance floor and the peg. Forecast credibility moves the scenario probabilities and the margin of safety and leaves the rate alone. With each risk named where it sits, none is counted twice.
The rate matures with the firm, moving across the fade years toward that of mature companies in the sector, and it is never lowered by assuming more debt than the business can carry.
Whether growth counts
Growth has to pass a gate before it is valued. The return on total invested capital, on the one definition the framework has used since the first anchor, has to exceed the cost of capital in each of the last three years. The barrier that explains the return also has to be shown, read from a map of competitors that names them and their share of each market the business serves. Shares that have held within a narrow band across three years show a barrier that works, and shares that drift show one that does not. The barrier itself is shown as captive customers, a cost advantage against named competitors, or local scale over a real fixed cost base. The map is dated and has to be recent, and a gate passed on a map that has gone out of date is not passed.
Does growth count?
The gate, in order. The first check the business fails sets growth to zero, and the business is valued on its earnings power alone.
Once through the gate, growth in each forecast year is the reinvestment rate multiplied by the return on new capital. That return is the register's marginal return on reinvested capital, because only the marginal return describes what the next dollar will earn; the average return on the whole base does not. It is pulled toward the sector's base rate in proportion to how few projects stand behind it. Growth is separated by type, since organic growth, pricing and acquisitions earn differently.
The period of excess returns starts from a named base rate, the median number of years businesses of this size keep earning above their cost of capital, and the business's own evidence may shorten it but never lengthen it. The return on new capital then fades in equal steps to the cost of capital, and mature growth is capped at the risk-free rate, the file's own estimate of how fast the economy grows. Where the gate is not passed, growth is valued at zero and the forecast runs at the mature rate from the first year.
Three layers
The valuation sets three figures side by side, all at the level of the enterprise so that leverage cannot tilt the comparison.
Three layers of one business
Illustrative, all at the enterprise level. Reproduction value is what a competitor would spend to rebuild the business; earnings power value is its no-growth cash flow capitalized at the cost of capital; the full DCF adds the growth that passed the gate.
Value, thousands of dollars
Earnings power is $2.3 million above what it would cost to rebuild the business, which is a franchise the gate has to prove. The $1.0 million of growth on top sits on its own line, so a buyer sees what it is paying for it and why.
Show the numbers
| Layer | Value, thousands of dollars |
|---|---|
| Reproduction | $5,200k |
| Earnings power | $7,500k |
| With growth | $8,500k |
Reproduction value is what a competitor would spend to rebuild the business before earning its first dollar: the assets at replacement cost less deferred maintenance, working capital at the peg, and the intangibles, from the customer base to the trained workforce and the brand, at what they would cost to reproduce. Earnings power value is the business as it stands with no growth: sustainable NOPAT less maintenance spending at the replacement plan, divided by the cost of capital. The value of growth is the excess of the DCF over earnings power, and it exists only behind the gate.
Reading the three together tells the buyer what kind of business it is looking at. Earnings power below reproduction value is a management problem, which a buyer prices as the cost of fixing it. Earnings power above reproduction value is a franchise, and the gate must prove it before any growth is added. Growth value sits on its own line, so the buyer sees what is being paid for the franchise and the owner sees what the reinvestment register has earned.
Illiquidity, reconciliation and the margin of safety
The holder here is the buyer of the whole business, so the discount for illiquidity is the cost and time of selling it, plus a small addition where few buyers are active at this size. That keeps it small. It is computed on the seller's own structure, so it does not move with how a particular buyer finances the purchase.
The three approaches are weighted by the strength of their evidence. With reviewed statements and a full multi-year record, the income approach scores highest and governs; weaker statements or a shorter record shift weight toward transaction evidence. The value is built before any offer or opinion of value is seen. Every price that arrives afterwards is reversed into what it implies, one input at a time, which names the input a buyer's bet rests on.
Scenarios sit beside the base. In the downside, the largest customer leaves, a capital overrun arrives, the budget misses by its worst variance and the largest project earns the register's worst return. In the upside, the best class of project is repeated. Where there is more than one owner, a co-owner's departure is priced through the buy-sell agreement. The margin of safety is the larger of two figures, the gap between the expected value and the downside, or a floor set for each layer that is smallest for reproduction value and largest for growth, so two people with the same file produce the same margin. The expectations the value rests on are written down, each with a signpost in the monthly package that would show it failing.
The file behind the number
Most of these inputs come from one driver on the last span, the Enterprise Value File. It produces what no other driver does: the return on all of the business's capital for three years, the competitor map and the advantage period it supports, the reproduction-value schedule, the cost of capital file, the scenario file, a log of every price received and what it implied, the analysis of growth by type, and the holder's own return. With it, a buyer's team can recompute every number in the valuation.
For the owner, the holder's return is the item to read first. It is the cash taken out during the crossing plus the change in equity value, set against the cost of equity over the same period, and it tells the owner whether crossing this bridge paid before they decide whether to cross the next.
Who underwrites it
The underwriter is a buyer who models rather than multiplies, and who will not pay for EBITDA that does not turn into cash. Being diversified, it prices risk as a cost of capital, where an owner would feel it as a personal exposure. A business that can show such a buyer its cash, its forecast and its file is valued on its own numbers.
What the crossing produced
The checkpoint at the end of the third bridge is the list the fourth bridge inspects on its first day, and it follows the four spans. From the first come classified capital spending under a written policy and a verified asset register with a replacement plan. The second leaves a working-capital definition and peg, a clean balance sheet, a schedule of debt-like items, and monthly cash flow statements with a forecast that records its own accuracy. The third leaves a reconciled tax memo and a written perimeter of sale. The fourth leaves a budget record, an integrated forecast, a reinvestment register with its returns and incremental margin, a growth-period statement, and the full valuation file. The essay on inspecting free cash flow to the firm sets each of them out.