Driving Your Company's Value

Growth and Productivity’s Five Dimensions of Value

Increasing a company’s return on equity requires that managers make all strategic decisions focusing on one or more of the Five Dimensions of Value. Every decision made should include the question of whether the action will accomplish the goals of one or more of the Five Dimensions of Value, which are related to growth and productivity within a company.

Growth Dimension will focus on —

• Increased market share using a constant capital investment.
• Invested capital in projects that yield a higher economic return, such as a new product line.

Productivity Dimension will focus on —

• Increased profits through operating efficiencies while using a constant capital structure.
• Maintained profits while using less capital through improved asset utilization (turnover).
• Maintained or improved profits while lowering the weighted average cost of capital (WACC).

Drilling Down the Dimensions of Value

Increasing market share using a constant capital investment. This means that long-term, consistent growth in profits can be accomplished only by expanding the company’s market share and therefore its revenues. The growth in the size of the marketplace may increase revenues temporarily without the company’s obtaining a larger market share, but eventually most markets flatten or decline in size due to many factors such as new technology or changes in consumers’ buying habits. Management must continually focus its efforts on increasing market share.

Investing capital in projects that yield a higher economic return. Consider a new product line: This simply means that a higher profit margin will increase a company’s free cash flow. An investment in a new, higher-margin product line will increase cash flow in two ways. First, each dollar of new sales will provide more free cash flow than the older product line. Second, new products will produce additional revenue from an expanded product line reaching a larger market.

Increasing profit through operating efficiencies while using a constant capital structure. This recognizes that profits and the related free cash flow can be increased through operating efficiencies, which lower operating costs without requiring investment in new assets. For example, companies can use overtime or a second shift without significant capital expenditure, as opposed to building a new factory or a factory addition.

Maintaining consistent profits while using less capital through improved asset utilization. This means that increased efficiencies will lower capital invested in the company and thus create excess assets, which can be distributed to the stockholders either directly or through cash generated by their liquidation. This additional free cash flow can be invested in other activities that will increase the shareholders’ total personal returns and total personal net worth without decreasing the value of the company.

Maintaining or improving profit while lowering the weighted average cost of capital (WACC). This recognizes that a company may not be using its available debt (other people’s money) appropriately.  Cost of capital is the combination of the return that the company is expected to pay its lenders and investors in return for the debt and equity capital it needs to operate the business.  Many private companies use little debt, perhaps for fear of the additional business/financial risk. This has the effect of establishing the company’s expected returns — or hurdle rate — at the higher equity level. This results in a higher WACC in the denominator, which lowers value. Utilizing appropriate debt levels that have interest rates lower than the equity return, results in lowering the weighted average of debt and equity (WACC).

A lower WACC in the denominator increases value. This tactic works in conjunction with the fourth dimension —increased asset utilization — to increase free cash flow. This extra money can be distributed to the stockholders or used to reduce the need for additional cash investments from the stockholders.

Summary

Focusing on value creation is a management mindset that must permeate every decision made by management.  Too often management focuses on one result of a decision but does not take a holistic view of the decision’s total affect on the business and its value.  By using the five dimensions of value as an decision making framework management can understand each decisions affect on the company’s value.

The Profit Equation

In 1971, the Boston Consulting Group promoted their very handy analysis tool for understanding a company's profit and its drivers.  They named this tool “The Profit Equation”.

The equation lists the key drivers of revenue growth and profitability. Once you have identified and quantified these items you can analyze them and focus in on improvements where they will add the most value. In addition, you can do very simple but valuable simulations to determine which items will have the greatest effect on profitability.

The equation is presented in a vertical format as follows:

                Existing # of Customers at Beginning of Period
                Plus: Customers Gained
                Less: Customers Lost
                Equals: Total Customers at End of the Period

                Times: Transactions per Customer
                Times: Average Sale Amount Per Transaction
                Equals: Total Revenue

                Less:  Cost of Sales

                Equals: Gross Profit
                Less  Selling and Administrative Expenses

                Equals: Net Operating Income

Take the time to calculate your company's profit equation. Build a simple model on an Excel spreadsheet and give it a try.  You will be surprised at the value of these simple management decision making tools, when you start to use them.

Value from an Investment Banker's Perspective - The 2nd in a Series

Intangibles, and How They Influence Market Value

Investment bankers deal in the real world of MARKET VALUE, but no value is established until a transaction takes place-a check is written, the contract for services and the earn out is negotiated and agreed to by all parties. We know from experience that all transactions, within a given industry, and for businesses of a certain size, have a range of value. That value is most often measured by a multiple of EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). Therefore, because there is a range of value as measured by a multiple of EBITDA, then there must be more to value than only EBITDA or there would not be a range.

Ignoring for the time being the differences in terms of the deals, and the variance of negotiating skills and competency (or lack thereof) of professionals on both sides of a transaction, the range of value can often be explained by the intangibles of the business. Intangibles are the aspects of the business that do not appear on the balance sheet but provide value to the business and influence the range of value as measured by EBITDA.

Let’s illustrate how important this can be for a business owner. Assuming a business is worth between 3.5 and 4.25 times EBITDA (and in most cases the range is substantially higher than this illustration) and assuming the EBITDA equals $1MM, the range of value amounts to $750,000 or a 21.4% premium. To a small or middle market business owner, this is significant and could amount to the difference between retiring in relative comfort and being able to achieve his or her personal goals, or not achieving them.

How can business owners obtain this 21% premium? We are often asked the most significant ways to improve value in a business. I have listed some of those intangibles below.

Ways for owners and managers to improve the value of a business through INTANGIBLES:

1) Provide for redundancy of management – acquirers do not want to buy a “one man shop.” There is too much risk associated with it and if competent management is in place, you increase the number of prospects to buy the business, thereby increasing the likelihood of obtaining a higher value. Owners should be able to take a three month vacation and come back to a better and stronger business than when they left. Work “ON” your business, not “IN” your business.

2) Cross-train your employees – this reduces risk and increases the number of buyers because you have a stronger business model.

3) Increase the business and financial literacy of all personnel in the company – if employees understand how their actions affect the bottom line (and what the bottom line really means) and how it affects them, they are more responsible in their actions and more productive. Employees are remarkably easier to motivate and manage when they understand the financial drivers of the company and financial transparency has been provided to them. This takes a commitment of resources, but will pay back ten fold in value and benefit to the company.

4) Implement and document systems – it takes the ambiguity out of daily activities. People will know how to handle situations and can “manage by exception” and not by emergency. Utilize customer resource management (CRM) programs, enterprise resource planning (ERP) programs, inventory control systems, sales and management, financial and accounting systems and document them all.

5) Diversify your customer and product base – don’t be overly concentrated in any one customer or product. Again, diversification decreases risk.

6) Have a written business plan in place and measure and compare financial pro forma with actual results. This allows your banker and a prospective buyer to see how the business is organized, how it makes money, how its profitability and cash flow can service debt and how value is created. It will also make it easier to sell the business based upon a higher future value.

7) Keep it simple – the business plan and model. If it is too complicated, the value of the business decreases.

If you address the above 7 points, you will have decreased the risk of your business and increased its value. You will have also lowered your cost of capital, which is a reflection of the perceived risk of your business, which increases value. You will have led to making some tangible improvements in value, such as increased free cash flow and increased asset utilization, which I will address through the “Value Formula” in the next article.



Visit http://www.pointebreak.com/ for more on creating business value.

Change: It’s not just for politics

Guest Post: Michael Mard, President, The Financial Valuation Group (www.fvginternational.com)

The world of accounting is changing. In fact, it’s standing on its head!  It will change the way we prepare our external financial statements provided to bankers and other interested parties. It will change the types of services you will need from your accountant or corporate finance advisor.

Bob Herz, the Chairman of the Financial Accounting Standards Board (the guys who set the rules for accounting), was interviewed in the February, 2008 issue of the Journal of Accountancy (http://www.aicpa.org/pubs/jofa/feb2008/robert_herz_interview.htm). In the interview, Bob talked about the convergence of world wide accounting standards, which is the blending of the U.S. Generally Accepted Accounting Principles (or GAAP) with the International Accounting Standards Board’s International Financial Reporting Standards. The coordinated effort will create more relevant information for the users of the financial statements, like banks and shareholders.

Now, while all that is interesting (perhaps), here is what caught my eye: in the middle of the article Bob talked about Enhanced Business Reporting providing key non-financial performance indicators. Specifically, Bob said: “… to understand a company’s performance and also understand where the company is going you need more than financial reporting. You need EBR (Enhanced Business Reporting). You need the key non-financial performance indicators. You need to put those in the context of the company’s strategy. Those will give you a much richer idea of what’s going on in the company and also those are often leading indicators to its future financial performance.”

The future is here: Financial statements reporting the company’s non-financial performance. The world of accounting is standing on its head!!