WHAT IMPACTS THE VALUE OF YOUR COMPANY?
By Adrian Loud
The value of a business is a function of “beauty in the eye of the beholder” and timing, but the theoretical way to quantify value is to estimate the company’s future cash flows and discount them to the present using a rate of return commensurate with the riskiness of the company. Expressed as a formula:
Value (V) = Cash Flow (CF) / (Rate of Return (R) – Long-term Growth Rate (G))
There is no single “value” of a company. Value changes over time and is subject to many influences, including: (1) economic and industry outlook, (2) company-specific attributes, and (3) motives of the buyer and seller in a transaction.
Ownership interests in closely-held businesses change periodically. Gifting, death, public offering, divorce, and other reasons drive transfers of businesses but the end-plan is typically some sort of sale or succession plan. The question business owners must ask themselves is, “Am I doing everything to maximize the value of my business for an eventual transfer?” Sounds like an easy question, but most business owners are too focused on the day-to-day operations to worry about preparing for a prospective transfer.
Buyers may adjust earnings to better estimate cash flow. The required rate of return differs from one buyer to the next, but should reflect: (1) the chances of realizing the estimated cash flow, (2) returns generated on similar investment opportunities, and (3) long-term growth opportunities. So how does the business owner maximize value? Based on the above formula, the owner should try to increase cash flow, reduce the risk associated with realizing the cash flow, and substantiate strong growth expectations. There are quantitative and qualitative factors that go into accomplishing this, briefly described below:
• The balance sheet is the company’s financial backbone. There must be sufficient assets (working capital, fixed assets, etc.) to operate the company. Furthermore, are receivables collected in a timely manner? Is a reasonable level of inventory kept? Are payables handled promptly? Is there too much debt compared to industry norms? Are there excess or nonoperating assets? Is the balance sheet current? Smaller companies keep internal financial statements while larger companies (several million dollars in revenues) should consider compiled, reviewed, or audited financial statements prepared by a CPA firm.
• The income statement is the starting point for the numerator in the above formula. It is also a useful tool for purposes of measuring performance from one period to the next. Some of the favorable metrics sought by buyers include stable or increasing profit margins, controlled operating expenses, minimal nonoperating and extraordinary income and expense items, and no owner manipulation.
• Growth trends in income statement and balance sheet fundamentals catch a buyer’s eye immediately. All things being equal, a company with a history of steady revenue and income growth is worth more than a company with flat or declining trends.
• Operationally, does the company run smoothly? Is the corporate culture healthy? Do employees understand and enjoy what they do? How does the company stack up against its peers in terms of technology, products, facilities, sales force, etc.?
• Solid management manifests itself in many ways. Ideally, there is no reliance on one or two members of management. The owner is no longer indispensible for periods of time. Employee morale is high and turnover is low. The income statement improves every year, and management is properly incentivized to perform at a high level and stick around long-term.
• Is there a roadmap for the future? A current, well-organized business plan articulates where the company has been and where it is going. Financial statement projections and supporting narrative about how goals and objectives will be achieved helps buyers and other parties better understand the business, and encourages management to hold itself accountable.
• Ownership may be too centralized or decentralized. It is often appropriate to gift shares or contribute shares to charities in an effort to minimize estate taxes. Conversely, if there are several unrelated shareholders who provide little or no benefit to the company, it may be prudent to repurchase those shares. This simplifies matters for buyers interested in acquiring 100 percent of the company.
There are no quick fixes for companies with holes in the above areas. Once all the holes are filled, continuous effort is required to keep up appearances. This is a comprehensive exercise, but if monitored successfully – will: (1) increase cash flow, (2) reduce the required rate of return, and (3) increase the long-term growth rate. All of which translates into higher value for the company.
Adrian Loud is a Senior Manager in the Valuation & Litigation Support Services Department at Bennett Thrasher, PC and can be reached at 770.396.2200 or firstname.lastname@example.org.