When we work with the many private companies we serve, especially those in some kind of transition, the value of the company’s capital is always an important part of the conversation – and justifiably so. The value of the business is often the biggest investment on the owner’s personal balance sheet and its value should be clearly understood.
Value is incredibly difficult to create in a private business because that value is often created by owners taking significant risks and building the company over time without access to large amounts of cheap outside capital public companies enjoy. The cost of this capital is high, almost immeasurable when you consider the risks owners take.
Because of this, it is critically important for owners to pay attention to the returns on their invested capital (ROIC) to compensate them for the risk they take. The only way value is created in a private company is when the company earns a return on invested capital that is greater than its cost of capital. There are four value drivers for increased ROIC.
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. 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. They concentrate their efforts in those areas to get the highest return on each dollar of sales.
Companies are not worth more because they have more assets, but rather, because of the efficiency with which the assets are utilized to generate sales and profits. That makes asset turnover an important metric. Asset turnover measures how many dollars of sales are generated per each dollar invested in assets. The company’s working capital is an area of significant emphasis in this regard. This goes to the question of how efficiently the company manages its level of accounts receivable and inventory in relation to its sales.
Fixed asset investments are another important area that can significantly affect asset utilization. Many companies do not focus on fixed asset investments because it is not a line item that affects net income. However, it is a utilization of the company’s cash and every company should have established return requirements before making fixed asset investments.
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; many owners have to personally guarantee some or all of their company’s debt, so they are generally debt averse. While we think it is wise not to over-leverage a company, we think it is also important to have clarity around when leverage can be beneficial as a source of capital to take advantage of opportunities to grow.
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. 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. Other things that affect business risk include the company’s strategy and competitive position, industry dynamics, quality of the management team, and customer or supplier concentrations. The key is to first identify the risks and understand the effect they have on value, then manage them as best as possible.
You may also like: