Yet, knowing how to get thereâto create valueâstill is not common knowledge. The goals of trusted advisors should include helping clients build and create value by ensuring they're aware of how to enhance their intangible assets' value and the options to do so. Advisors must also recognize owners have limited time to shepherd growth, so having a plan is insufficient. Having resources to execute the plan is what's needed. Successful business owners and their advisors already know it's not simply selling more services and products profitably.
Let's be clear from the beginning. Tracking revenue growth and profitability oversimplifies the complexity of an operating business. Doing so fails to examine the influence of invested capital. Invested capital examines both the use and optimization of a company's assets and liabilities (debt and its leverage as well as its risk sharing attributes). Here is a simple example: If a company has reasonable growth and profitability, it does not necessarily follow that it has performed its cash, accounts receivable, or inventory management well. It also follows that if these tangible assets have not been adequately considered, then what about the intangible assets such as human capital (i.e., governance, relationships, and knowledge) where such attributes are not found on a financial statement, but clearly have a significant impact on performance and value?
It stands to reason that most company founders understandably confuse their roles as owner-investors, officers, and employees of their companies. They may not have had the benefit of more rigorous financial training. However, what is the excuse of business advisors of all kinds who have a fiduciary duty that is greater than selling a service or product. For example, how does an owner allocate assets if she or he doesn't have a full understanding of the risks and value of one of their largest assetsâthe company? How does financial reporting for tax purposes help create more intangible value? How do rates and terms alone impact the overall business in order to be more competitive in its marketplace?
Value is more than a number. The previous paragraphs ought to give pause. If value were as simple as affixing a number based on a universally accepted formula, there'd never be any disagreements between owners and the IRS, between buyers and sellers, and between any other interested parties. This is especially true for private and thinly traded public companies. The most common way to determine value is by gauging the rate of risk (return) associated with an asset's ability to generate free cash flowâand that leaves room for a lot of gray area (whose idea of risk? what period and duration of time?).
Arguably, that is where intellectual rigor and due diligence that looks beyond financial statements and forecasts is required. Mastering operational risk identification, measurement (benchmarking), and management are musts.
In Driving Your Company's Value: Strategic Benchmarking for Value, Michael J. Mard expresses, âManagement must understand that a focus on value creation is a holistic endeavor that is constantly and consistently applied.â1
Return on invested capital (ROIC) and strengths, weaknesses, opportunities, and threats (SWOT) analysis as well as associated due diligence are important considerations of value building and creation. Such analyses can and should provide benchmarks including soft and hard measures (human and financial capital). An example of a soft measure would be employee morale. A hard measure might be annual staff turnover. Common performance metrics are:
- Linked to strategy
- Clearly defined
- Understandable
- Easily measured
- Few in number
- Reported regularly
- Consistent follow-through
- Openly shared
- Predictive in nature
- Developed by everyone
- Team or unit based
- Tested against behavioral outcomes
- Assessed and modified regularly
- Linked to compensation
So, a value is determined by establishing economic benefit, such as profit, net income, EBITDA, or cash flow. That's the numerator. Let's say it's $10 million. The remaining variables are growth and risk or the denominator stated as a percentage.
If the risk measurement was opined to be 25 percent (expected investor return), then the equation would be $10 million/.25 or $40 million in value. The lower the risk, the higher the value.
So, let's apply 20 percent instead of 25 percent to prove this point, of lower risk. The value would be $50 million or $10 million/.20. Stated another way, using 25 percent is the same thing as applying a price multiple of 4Ă or four times. Using 20 percent is the same as applying 5Ă.
So, while seemingly straightforward, the tough part is âWhat is the risk (multiple)?â This issue is at the heart of what drives investor expectations and the difference between skilled research and analytics versus an otherwise expensive, unsupported result. Thus, the lower fee for services does not matter if the value is incorrect or unsupported.
Behavioral finance does play a role in the valuation process. It's more difficult to discern value in private companies, where data is not as easy to come by compared to their public company counterparts. At the center of it all, does the company's upside investment potential outweigh its perceived level of risk?
Therein lies the Achilles' heel of valuation: making assumptions of risk and future economic benefit. It behooves anyone with a stake to ensure adequate empirical factors are considered. This means that while legal and financial issues are relevant, operational and human capital issues are often overlooked and inadequately portrayedâand that omission can significantly impact value.
Keep in mind there are assets that are seen and reported. These are tangible assets. What a business appraiser is most often retained to opine is the unseen or intangible asset values. A successful business has an ever increasing part of its value associated with intangible assets, such as, but not limited to, goodwill.
A simple illustration is the comparison of public companies Wells Fargo Bank and Bank of America six-plus years after the Great Recession of 2009. The reported price to book value (P/BV) of Wells Fargo and Bank of America was 1.69Ă and .82Ă, respectively. This means the former's price multiple is more than twice the latter's.
More importantly, Wells Fargo enjoys intangible value (as an operational primarily asset-based holding company that exceeds 100% of its book value). That additional value is all intangible. This is likely associated with solid client relationships and reputation. Meanwhile, Bank of America's value is actually below its book value as of this book's writing.
This is not good as is suggested by Wall Street analysts who recommend a âBuyâ for Wells Fargo and a âSell/Holdâ for Bank of America. Also, the companies' measured volatility compared to the industry/sector, with a 1.0 being the median and over 1.0 being more volatile (risky) and below 1.0 being more stable, further proves the point. Bank of America's volatility (beta) was 1.59 as compared to Wells Fargo's 0.86.
Capital and Risk
Company size can be a significant consideration when it comes to risk, especially with regard to securing capital. As you might expect, larger companies usually have more options and better access to the capital markets as well as better rates and terms. A $1 billion company may have funding sources bending over backwards to provide financial support while a $25 million company may need its owner to make a personal guarantee to be considered for a loan/credit facility.
The less risk perceived, the better rates and terms offered. That can pay huge dividends for larger companies, with which capital sources, such as banks, are more likely to share risk. However, size is not an absolute because growth and niche market dominance are examples of factors that could suggest a smaller company may have the potential of less risk and higher value. Sharp company owners have an idea what their company-specific risk rate is and how to spread risk by having debt allowing the lender to share the risk.
Let's use for illustrative purposes only the previous example of the $50 million company with the $10 million net cash flow and an assumed 20 percent risk rate. Let's assume our research of comparable companies indicates the optimal level of debt to equity is 50/50. So, we determined that 50 percent has a 20 percent rate for equity. This would be shown by (1 â .50).20 = .10 or 10 percent allocated to equity.
Let's then say that interest rate from the lending source is 5 percent and since interest expenses are tax deductible, that the combined state and federal tax rate is 40 percent. That means that the true cost of capital is (1 â .40).05 or 3.0 percent. Since debt represents half, we now have our new rate of (1 â .50).03 or 1.5 percent. The 1.5 percent debt rate is combined with the 10 percent equity rate for the weighted average cost of capital (WACC) of 10 percent + 1.5 percent = 11.5 percent. This is 42.5 percent lower than the 20 percent rate or risk for equity alone without debt. This improves the market value of invested capital by sharing risk with the note holder.
Remember, the lower the risk, the lower the rate. The lower the rate, the higher the pricing multiple and value.
Finally, assume the $25 million debt allows the company to produce twice the widgets in half the time, reducing labor expenses. So, despite the new interest expense and repayment of principal, the increased profits are $15 million versus the $10 million.
This means the value of the company is $15 million/11.5 percent or $130.5 million (rounded) less $25 million in debt or $105.5 million in value. This is more than twice the $50 million value even prior to finding other areas where risk may be mitigated and/or minimized. This is why as a strategic value architect, it is possible to claim that in as brief as 24 months a compan...
