Nick Sypniewski, ASA, Managing Director, ComStock Advisors
There are a variety of ways to value businesses and plenty of ways to improve any specific business (and, thus, its value). This can result in a lot of potential advice. In setting priorities for action, it is useful to organize advice and ideas around the core of what drives business value, which includes five areas: cash flow, risk, growth, the market and the balance sheet.
Maximize Cash Flow
An investor is interested in the future benefits that ownership will yield – that is, what are the future available cash flows? Historical earnings matter to the extent that they are an indication of future earning power, but in fact, it is the future that matters. Improving profit margins is one approach to improving cash flow, but note that cash flow does not equal net income. A growing company typically needs to reinvest in working capital and fixed assets to support growth. That reinvestment reduces cash flow available to the owner, so managing working capital and capital expenditures is important to enhancing cash flow and value.
Valuation multiples are often cited for various industries, but underlying these multiples is the risk and growth associated with the industry (or more importantly, with a specific company). The cost of capital for a company is a measure of the market’s assessment of the risk of that company relative to other investments.
In this context, risk is a measure of uncertainty – or volatility – surrounding the generation of cash flows. Sometimes, risk is obvious because a company has experienced volatility in the past. But sometimes risk is hidden; the steady hand of the veteran president or the significant long-term customer can mask the risks associated with the potential future loss of a key person or key customer. Understanding and mitigating risk factors to reduce current and potential future volatility enhances value.
All other factors being equal, a company whose cash flows are expected to steadily increase over time will be more valuable than a company whose earnings are expected to remain flat. For example, if a low-growth (say 2 percent) company is worth 4 times EBITDA, then a comparable company with 5 percent growth would be worth 5.2 times EBITDA – an increase in value of 30 percent. (Note: there are some assumptions about risk and reinvestment in this example, but the importance of growth still holds true.)
There are three points to keep in mind regarding growth:
- Pursuing growth would seem to mean taking some risk. However, one could argue that it is far riskier to try to maintain the status quo in an ever-changing world.
- Growth does entail reinvesting in the company, which can reduce cash flow in the short-term in exchange for long-term growth in cash flow.
- Remember – it is cash flow growth, NOT just sales growth that drives value. Plenty of companies have grown themselves into bankruptcy by running out of cash as they pursued unprofitable sales.
Understand Market Conditions
Try as one may to enhance cash flow, reduce risk and pursue growth, the fact is that not all things are within a business owner’s control. The value of a business is impacted by external market conditions regardless of how the company is performing. Understanding the market can help a business outperform its peers; however, even a well-performing company in an out-of-favor industry may have difficulty convincing investors (including banks) of the merits of investing in or lending to the company. Therefore, being able to communicate your understanding of the market to others is important. Understand and be able to explain why the business is outperforming its peers, especially if an industry downturn is allowing your company to improve its position relative to the competition, which can generate large benefits in the next upturn. (On the flip side, don’t be complacent if the company is enjoying success in an up market.)
The balance sheet matters – maybe not so much if the company is being sold, but for an ongoing business, the financial condition of the company impacts value. A company with a strong balance sheet and cash reserves is more likely to weather adverse conditions or be able to move quickly when opportunities arise. An overleveraged company may have little margin for error (although the prudent use of leverage can enhance the return on investment to the shareholder, i.e., value).
A business owner can increase value by understanding and optimizing the factors that enhance the value of the business. Specific factors vary from company to company, but most will fit into one of the five core categories above.