Most private company owners have a substantial portion of their wealth tied up in their company, so the value of that asset and increasing its value are critical. Fundamentally, value is created in a business when it earns a Return on Invested Capital (ROIC) that is greater than its cost of capital. ROIC is a measure that compares the relative size of the profits to the amount of capital at risk to produce the profits.
The most valuable companies we work with create a high ROIC. They do this by actively managing a four value drivers: margins, asset utilization, leverage, and risk.
High gross and net margins are the most important driver of increased value in a business. Note that I said gross and net. It isn’t just the sheer amount of profits that is valuable, but the efficiency with which the business creates them. A business that nets $0.10 for every $1 of sales is more valuable than one that nets $0.05 on every $1. A company’s level of gross margins is typically the driver of its net margins.
The most profitable companies we work with are highly disciplined about the seemingly never-ending chase for volume. They focus on profitable sales, not just the top line. These companies generate higher margins because they have clarity about which customers and markets to focus on and where they should concentrate their efforts to get the highest return on each dollar of sales. This means they don’t try to be all things to all people. They are discerning about which business and customers to accept and are willing to say no if an opportunity arises that doesn’t fit their requirements.
On the other hand, companies that focus solely on volume ultimately work harder (not smarter) and take more risk. They need more of everything – space, people, insurance, administration, etc. – which means they’re creating higher cost structures without the corresponding payoff. This lowers margins and, in turn, lowers the company’s value.
Here are a few key considerations related to margin:
- Does your company have a clear strategy and value proposition in the market and with the customers it chooses to serve? Is everyone in the company crystal clear about this strategy?
- Does your current customer and product mix fit with your margin requirements?
- Do your incentive programs reward volumes or margins?
- Do you have the discipline to say no to opportunities that don’t fit your strategy?
Asset utilization affects value in two ways. As stated above, margins matter in the valuation of a company, which should manifest itself in cash flow. The allocation of this cash flow for reinvestment in the business also affects the value of the business. Just because fixed asset purchases are not an expense on a GAAP income statement doesn’t mean they aren’t a real claim on the company’s cash flow from earnings.
As a general rule, “asset light” companies are more valuable that “asset heavy” companies because more of the profits are available to the shareholders since they aren’t being reinvested in the business. This isn’t to say you shouldn’t reinvest in your business; every company needs a reasonable reinvestment rate in fixed assets to ensure its future survival. The question is whether you have a rigorous evaluation process to ensure an adequate ROI before capital is deployed to purchase fixed assets. We find a lot of lost value in companies that don’t approach this issue properly because it doesn’t show up on their income statement. Bad reinvestment decisions reduce the value of your company.
Generally, companies are not worth more because they have more assets, but the assets they own are a requirement to generate sales. A company is valued more highly when its assets are efficiently utilized in a manner that maximizes sales, profits, and cash flow. The measure for this – asset turnover – considers how many dollars the business generates for each dollar of assets being employed. It is a reflection on the management of the business. It stands to reason that a company that creates $20 of sales for each $1 of assets it employs is going to be more valuable than a company that generates $10 of sales for each $1 of assets it employs.
A few considerations in this regard are as follows:
- Does your company have rigorous requirements for the commitment of resources for fixed asset purchases?
- Do you have appropriate metrics to monitor turnover of accounts receivable and inventory?
- Does your company generate cash or does building cash balances always seem to be an elusive goal?
Financial leverage can affect a company’s value depending on the blend of debt and equity capital it uses to finance the business. This is a tenuous balance in a private company where many owners have to personally guarantee some or all of their company’s debt.
The widespread use of leverage can put the company at risk because it is your friend when the tide is high but can cause great harm when business declines. However, while too much leverage is not a good idea, many companies don’t realize that too little leverage can reduce value because it constrains your ability to grow.
Assets are necessary to generate sales, so it is important to determine how to accumulate more assets to take advantage of market opportunities. If you have $5 of equity and no debt, you have the ability to control $5 of assets. While this is certainly safe, it may not put your company in the best position for growth. Using the same example, you could control $10 of assets with a blend of $5 of equity and $5 of debt. This would produce a ratio of debt to equity of 1:1 which is considered very modest.
The decisions around when and how to use debt have a lot to do with the characteristics of your business and the potential risks associated with pursuing new opportunities. It is a complex analysis that requires prudence; however, too much or too little leverage can have negative effects on value.
Our final lever is risk. From a value creation standpoint, there is an inverse correlation between a company’s risk and the relevant multiple for the business. Higher risk denotes a lower multiple, while lower risk denotes a higher multiple.
Some risks are harder to manage than others. One sign that a company has a good handle on its risk is the relative consistency of its operating results. Large volatility in results generally reflects a business with greater risk. Earnings volatility could be associated with different kinds of risk including industry economics, business model, quality of your management team, etc.
Here is a short list of risk management considerations:
- Are your company’s results stable are durable?
- Does the business have clear governance principles and structure in place?
- Is there a succession plan in place for key people?
- Is the business dependent on the owner or is there an adequate management team?
- Are there customer or supplier concentrations?
Many private company owners have most of their net worth in their company stock, yet don’t place enough emphasis on driving that value higher. Benchmarking the value of your company and understanding the things that drive value are a worthy use on any owner’s time and attention.
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