The business press is often confusing regarding value and businesses.  We can read articles on one strategy or another, on supply chain management, on accounts receivable or inventory management, on productivity, and on many other topics that seem to relate to the value of businesses.  When we read these articles, however, it is helpful to keep in mind that the story of the value of any business must ultimately be described using three factors.  Keeping this in mind helps to place all else into appropriate perspective.

The three factors are, for any business, its 1) expected cash flow (say for the coming year), 2) the expected growth (rate and variability) of those cash flows, and 3) the risks associated with achieving the expected cash flows.

There is a basic equation, called the Gordon Model, which summarizes the value relationships:

1. Value = CF / (R – G)

CF stands for expected cash flow, or earnings.  R symbolizes the discount rate, or the rate that is reflective of the risks associated with achieving the expected cash flows and that is used to bring expected future dollars to their present value.  Finally, the G is the long-term growth rate of the expected cash flows.  Using some basic algebra, we see that (1 / (R – G)), i.e., the denominator of the equation above, is a multiple.  For example, if the discount rate (R) is 15% and the expected growth rate (G) is 5%, then the implied multiple associated with expected cash flow (CF, or simply, Earnings), is 10.0x (1 / (15% – 5%)).  So these three factors, CF, R and G can be summarized:

2. Value = Earnings x Multiple

Business people are familiar with the second equation, and Earnings can be net income, pre-tax income, or EBITDA (earnings before interest, taxes, depreciation, and amortization).  However, the purpose of this short post is to concentrate on the three value-building factors, two of which are contained with the valuation multiple associated with a business.

Expected Cash Flow (CF) or Earnings

We can look at earnings in many ways, but earnings are the residual from the revenue of a business less all of the expenses associated with generating those revenues.  In Equations 1 and 2 above, the expected cash flows, or earnings are “capitalized” or “multiplied” based on the risks associated with achieving them and their expected growth, as we will talk about shortly.  Stated at its simplest, earnings can be defined as:

3. Earnings = Revenue – Expenses

Given this equation, it is apparent that there are three basic ways to increase earnings over any period of time:

1. Increase revenue while holding expenses constant (a price increase, perhaps)
2. Hold revenue constant while decreasing expenses (more efficient production, maybe)
3. Increase revenue while increasing expenses at a slightly lower rate (for example, a sustained focus on productivity enhancements over time)

Any way you cut it, earnings are increased in basic ways, and increases in earnings increase value, assuming other things remain the same.  More expected earnings means more value today.

So when we read about sophisticated strategies and seemingly complex implementation schemes, remember this simple fact:

Increasing earnings increases business value.

Unfortunately, the opposite is also true.  Decreasing earnings tend to diminish value.

Let’s look at one variation of this equation:

4. Margin = Earnings / Revenue

If we increase earnings relative to revenues, we increase the margin, or profit margin.  So when you look at your business, think about ways to extract additional margin from your revenues.

I know these concepts are simple, but they are so basic they are often overlooked.  When you look at your business, think about ways to increase revenue at the margin, or to decrease expenses, absolutely or at the margin.  If you find ways to do this, you will increase the value of your business.

Expected Growth (G)

Looking back at Equation 1 above, we see that G, or expected growth, is in the denominator with a negative sign.  The math is simple. We saw that with a discount rate of 15% and expected growth of 5%, the multiple is 10.0x.  If we increase the growth rate to 6%, other things equal, the implied multiple rises to 11.1x (1 / (15% – 6%)).  What the G relates to is the expected growth in the earnings or CF in the denominator.  Faster growth means more cash flows in the future, so more value today.

Growth is important because there is a tendency to lose customer relationships over time.  We have to develop new customers to replace normal customer attrition, and then, we have to gain even more customers if a business is expected to grow. We can enhance growth in a number of ways, including:

1. Increasing sales to existing customers
2. Generating sales to new customers
3. Having an inventor ideas in creating new products to sell to existing customers (and future customers)
4. Increasing customer retention while continuing to develop new customers
5. Others

There are natural barriers to growth for many companies.  These barriers include competition, limitations of existing plant and equipment or of trained personnel, limitations of critical inputs, and others.  So we can increase growth by eliminating barriers to growth.

Business growth can be complicated, but at its core, it relates to the ability to acquire new customers and to grow the customer base, and to develop new products or services to expand the reach of your business.  So look at your business from the viewpoint of how you can increase growth.

Discount Rate (R)

The value of a business today is the present value of all expected future cash flows from the business (the CF we are discussing above and the expected growth of those cash flows), discounted to the present at a discount rate reflective of the risk associated with achieving those cash flows.  So R embodies all of the expected risks associated with achieving expected future cash flows.  I’ll do a post on the discount rate itself shortly.  For now, let’s focus on basics.

R is in the denominator of Equation 1 above with a positive sign.  If risk increases, other things being equal, value will be lowered.  If risk is decreased, then value will be increased.  This makes sense.  Treasury rates are lower than the rates charged for debt of investment grade corporations which are lower than the rates charged for junk bonds.  Interest rates on bonds increase with increases in perceived risk.  The same is true for businesses.  Risk can be reduced in a number of ways, including:

1. Reducing customer concentrations over time
2. Reducing dependency on a single product, or by diversifying the product offerings
3. Reducing dependency on one or more key persons in a business
4. Enhancing the profitability (i.e., the margin) of the business
5. Others

The idea is to look at your business from the viewpoint of other, future investors.  Eliminate the risks that they would see right now, so that over time, the riskiness associated with your expected cash flows is reduced and the value is increased.

Conclusion

Growing a business and increasing its value can be complex in execution and can take considerable time.  If your business is growing, you are focused on many things in a variety of ways.  But all of them, in one way or another, related back to the three valuation factors of CF, R and G that we have been discussing.

If your business is not growing, begin to look at it through these three filters.  Begin with CF or earnings, perhaps.  How can you use the simple ideas expressed above to implement changes to increase earnings?  What can you do to reduce customer attrition (increase retention) to increase growth (G)?  What can you do over time to reduce risks associated with your business (R).

Questions?

Look around this blog.  I’m addressing many questions that business owners have asked and many more questions that I’ve heard about or observed.  My answers will not be technical, but hopefully explanatory and illustrative of important business valuation concepts.  If you have a question, comment on this post, email me (mercerc@mercercapital.com), or call me (901-685-2120).

If you know you need a business valuation and would like to receive a complimentary proposal, click here or call me at 901-685-2120.

If you would like to talk to me about your business and its value, about a transaction you are considering, or about any thorny management or ownership transition issues in a complimentary initial phone session, call 901-685-2120 and ask for Todd Lowe, my executive assistant.  He’ll schedule a workable time for us, or, if serendipity strikes, we’ll talk when you call.

For additional perspective business value, see these posts on identifiable earnings and transferable business value.

Until next time,

Chris