What Factors Contribute to the Valuation of a Company?
Valuation Blog Series 1 of 6
Often times the business valuation process follows a similar story arch. Initially, owners are hesitant to engage an outside analyst, believing they already know the value of their business—and they may view the process as an unnecessary expense to accomplish their goals. After discussions with their trusted advisors, they are finally convinced that a business valuation engagement is a necessary and valuable exercise.
For the business owners that take the business valuation process seriously and engage in the project, they ultimately realize that a business valuation report is more than just a number; it’s a powerful document that provides deep insights into the inner workings of their company. And had they engaged in a valuation process sooner, they may have been able to more strategically influence the “levers of value” and more successfully achieve their goals, e.g. maximize their company’s value.
Levers that Drive Value
The process of obtaining a business valuation makes owners think critically about the operations of their business, frame their understanding of the term “value” to allow for more productive conversations, and most importantly, helps them gain an understanding of the relationship between the levers that drive value and how their business is capable of adjusting those levers.
At a high level, the levers that drive value can be broken down into three areas: company metrics, risk, and growth. Understanding the importance of these areas and how they effect the approaches that business valuation analysts utilize when valuing a business is key for business owners to maximize value.
There are only three approaches to valuing a business; the asset approach, the income approach, and the market approach. For the majority of businesses, the asset approach is not typically relied upon as it is more generally utilized for businesses that do not have a substantial intangible value. That leaves the income and market approaches.
The income approach can be simplified to this equation: value equals an earnings metric of the company divided by the risk, or discount rate, associated with achieving that earnings stream into the future. The market approach can be simplified with this equation: value equals an earnings metric of the company multiplied by a multiple. These two ways to approach value are tied together in that, theoretically, the discount rate used in the income approach should be the inverse of the market multiple used in the market approach (adjusted for long-term growth).
Within the market approach, multiples are driven by two levers; risk and growth expectations. Given the relationship to the income approach, these two levers are also the main drivers in determining the discount rate. By understanding the relationship between the income approach and market approach, we can see that any valuation conclusion is going to come down to the current company metrics, risk, and growth expectations.
Lever 1: Company metrics
In all valuations, the analyst starts by examining the current state of the company’s financial health. Within the income approach, the numerator in the valuation is most often the free cash flows or net income of the company. For the market approach, company metrics most often utilized are revenues or EBITDA (earnings before interest, taxes, depreciation, and amortization). In both these cases, the higher the company metrics, the higher the value. While it should be fairly obvious that increasing revenues and improving profitability should lead to higher valuations, the factors that drive higher company metrics are important considerations to make when looking to increase value.
To understand the free cash flows of the company, the valuation analyst starts at the top of the income statement and works their way down. They will then work their way through the cash flow statement. The insights garnered via each line item will have a cascading effect on the following line items and the conclusions generated by the analyst.
Revenue and revenue growth
An analyst doesn’t just want to know that your company plans to grow, they want to understand how and what that growth looks like. For example, let’s say a company wants to growth 5% in the next year. Management should be able to discuss where that 5% will come from and what impact that has on the bottom line. This discussion should center on questions such as;
- What percentage of the prior year’s revenue is recurring or comes from customers you know you can count on?
- What percentage of the prior year’s revenue will you lose? To achieve 5% growth in a year, will you need to grow at a percentage higher than that to make up for lost revenues?
- Will any of the growth come from pricing increases? How susceptible are your customers to absorbing price increases?
- Do you have a new product or service line that will help achieve your growth?
- Can you cross-sell new products or service lines to existing customers, or will you have to gain new customers?
Margins and operating expenses
Developing a revenue growth strategy should help business owners fill in gaps for the rest of their financials. If new product services are part of the growth strategy, how will the new mix affect margins? Are current employee levels and facilities enough to absorb anticipated growth? What new selling and marketing expenses are required to help drive our revenue growth to hit our goal? Thinking along these lines will help business owners manage their net income and make changes necessary to help the bottom line increase.
Revenue growth typically requires investments in the company to be made for items like new equipment, new technology to help efficiency, buildings for more space, additionally inventory, etc. To adequately fund growth, businesses need to reinvest in themselves and understand where that money is coming from. This is one of the most important metrics business owners need to understand.
While the profitability of a business should be the main driver for most of the reinvestment, having an understanding of their collection and payable cycles helps drive the understanding of how much free cash flow the company actually generates.
Lever 2: Analyzing Risk
Once you have an understanding of the metrics of the company, next it is important to understand the risks associated with an investment in the company. There are two risk types that influence the expected return of an investment: Systematic risk is best described as the external economic factors that affect most companies. Unsystematic risk is often described as the company-specific risk that can be related to multiple factors.
To a large extent, the systemic risk cannot be adjusted by a business owner and is largely driven by the market. There is a spectrum of investment options where investors can invest their money and each has an inherent risk profile in the market. On one end of the spectrum are government-issued debts such as U.S. Treasury Notes which are short-term debt obligations backed by the U.S. government. They are often considered risk-free, as the risk of default is deemed non-existent. As you move across the spectrum of investments, additional risk factors are considered therefore increasing the rate of return. Other somewhat risky investments can include farmland, residential and commercial real estate, and corporate bonds. When you get to equities as an investment class, financial risk—such as the quality and stability of earnings and the size of the entity—also has a significant influence on overall risk. Larger companies typically carry less risk than smaller, non-publicly traded companies, for example.
Business owners should focus on the unsystematic risk associated with their company. This will include company-specific factors like:
- Is there a management team in place? For example, smaller companies typically have a founder that drives everything from strategy to day-to-day operations. If something were to happen to them, the company may cease to exist. Business owners should focus on developing a strong, diversified leadership team.
- How diversified is the company’s customer base? If a substantial amount of revenue is derived from very few customers, the company has a substantial risk of loss that could greatly impact operations if they were to lose one of their top customers. For small businesses, it is important to have a strong customer mix which will allow the company to absorb any loss of customers without a major impact to their operations.
- Additional areas of risk to address include geographical diversity, product diversity, supplier concentration, competitive strengths and weaknesses, quality and variability of earnings, degree of leverage, liquidity, and access to sources of capital should also be considered by company management.
While smaller privately-held businesses are always going to inherently more risky than other investment options, addressing and limiting risk in the areas that business owners can control, can help maximize the value of their company.
Lever 3: Growth
Growth plays an important role in the value of companies because all value is forward-looking. The more growth the company experiences, the more free cash flow the company can generate which is attractive to a potential buyer.
Looking at growth from a purely mathematical basis and holding all other considerations constant, growth will exponentially increase the multiples to be paid for companies.
However, in practice, buyers will view growth differently with their analysis being shaped by the following factors:
- Anticipated growth rates
- Company growth history
- Ability to sustain the company’s growth trajectory
- Management’s documented strategy to deliver on growth promises
- Business scalability
- Necessary level of capital of investment to fund anticipated growth
- Market risks that may derail growth plans
Business owners, especially ones planning to sell their business, need to ensure that they have historical financial statements supporting their growth story, a documented growth strategy, and a plan to mitigate any potential risks along the way.
Understanding all the levers of value and and their effect on the business valuation provides business owners with the knowledge and insights necessary to strategically drive more productive conversations, change operational strategy, and ultimately, realize more value for their business.