KUHN CAPITAL Tuesday, October 17, 2017
Dispatches from the front

Calculating & Enhancing Market Value
(8/11/2003)

Take a tour of the various valuation techniques used to place a number on your business, but more importantly, learn about the sorts of actions and characteristics that drive high values.

The Calculated Approach
We are frequently asked by clients to estimate the value of a business for a variety of purposes:
* To plan and organize estate and tax strategies;
* To determine if the owners should consider the company’s sale, or to develop an expectation of the company’s fair market value in negotiation with buyers;
* To confirm the value of a prospective acquisition target.

The object of a valuation exercise is to utilize multiple analytic tools that ideally produce a collection of similar values. (However unfortunately, the most definitive source of value metrics is derived from an analysis of comparable public companies and sales transactions, but these approaches typically generate values that are both among the highest and most variable.)

Valuations tools approach the task from differing perspectives. We’ve briefly described six such approaches below:

Liquidation Value
What would the business’ assets fetch in the open market net of liabilities? This technique assumes an orderly auction sale of individual assets and so, by definition, it does not account for the present value of future cash flows generated by a going business. Therefore, the technique tends to be most relevant when the business is cash flow negative with poor prospects for continued independent operation. See our prior Dispatch on this subject for suggestions on how to value intellectual property assets in particular, a notoriously difficult task.

Replacement Cost
Assuming that a competitor or other player desires to enter the seller’s business, what would it cost them to duplicate certain of the seller’s resources? Of course, to imagine this scenario, one would have to confirm that at least some components of the business are sufficiently attractive for a third party to consider duplicating. Keep in mind that intellectual property replacement costs are fair game here – e.g., for a brand’s name recognition that can reduce a new owners’ marketing costs, or for software code. But in any case, simply calculating the replacement costs of a business without regard to whether doing so would generate a profit is an empty exercise.

Going-Business Value
Estimates the future cash flows of the business and captures that value in the form of net present value. Since this process emphasis future performance, it places a great deal of weight on accurate forecasting and on the “discount” rates fairly applied to future cash flows in order to account for risk and the costs of capital.

Public Company Market Capitalizations
Examines public companies similar in one or more respects to the seller’s business, and typically discounts this value if the seller is substantially smaller and/or private. Finding exactly comparable public models is typically quite difficult, so the more sophisticated versions of this analysis segregate out similar business lines and value them independently.

Sales of Comparable Entities & Products
Tracks transaction values for similar businesses in an effort to uncover the purchase rationale and terms. What’s difficult about this process is uncovering sufficient detail about the private transaction to create valuation metrics. However, when such data are available, they can often be the most relevant.

Market Survey
Retaining a professional M&A advisor with strong industry contacts to inquire among prospective buyers can often produce immediately relevant valuation estimates. Of course, such a campaign must be undertaken with discretion and, typically, complete anonymity.

We could write pages more on each of these techniques, but our main interest here is to describe something you should find more immediately practical and useful: how to enhance value.

Value Drivers
While valuation exercises are useful, even necessary for many reasons, they typically don’t look at the underlying dynamic processes that actually generate value: rather, they quantify what those processes have accomplished.

What are the sorts of operating and strategic factors that create the values captured in valuation exercises? Some of these factors are found in many industries, but some are unique to IT and BPO businesses. Once you know what factors drive perceptions of value, you are in a better position to measure and manage them to benefit your company.

Client Relations
Drivers: number of clients, average sale per client, loyalty (as measured by multi-year revenues), client size, industry (or “vertical”). In a word, the higher these metrics are, the more value is perceived. Example: in general, large, loyal clients are valued more dearly than small, new or former clients. And certain client industries are often perceived as rich and large, like financial services and pharma, while others are “poor” like sole proprietor dry cleaning stores.

Financial Performance
Drivers: sales growth, profitability, operating cash flow, operating leverage. Obviously, the longer the period of time that the company has established a track record for rapid, profitable growth with positive cash flow, the more valuable. Also, for a product company, is the proportion of license and maintenance revenue high? These sources of product sale represent a more reliable stream of future cash flow than, say, a handful of very large service revenue clients who go away after a project is completed. And if a company has a fixed cost infrastructure with substantial unused capacity but growing sales, these facts imply a large degree of operating leverage, or the ability to generate incremental sales at lower variable cost and without immediate additional capital expenditure.

Product/Service
Drivers: end-user’s perception of quality and reliability, level of recruiting or R&D investment, product currency, evidence of market pricing power. End-user perceptions may be elicited through surveys or interviews, a fixture in many buyers’ due diligence process.

Operations
Drivers: scalability of product or service model, quality of control systems, management team depth and quality, employee morale, length of sales cycle. In fact, the accuracy and currency of the seller’s information systems are also critical in responding to due diligence requests and in creating the impression that the company is well-managed.

Strategic Considerations
Is the industry a commodity supplier, or heading in that direction? Are strong competitors breathing down the target company’s neck, or does the company operate in a well-protected niche? Conversely, if the company is operating in a niche market, are there constraints on future revenue growth? Does it enjoy a first, second or at least third market share position? Do government regulations impose constraints on growth or opportunities? What is the condition of the clients’ industries?

While some of these value drivers are relatively fixed, like the sort of industry in which the company operates, or its market share, a number of others can be manipulated in the short term at acceptable cost. Specifically, owners can improve their company’s information systems and management team’s quality rather quickly: in our experience, such changes return many-fold their expense in enhanced value. In other cases, like those associated with establishing clear growth trends, waiting a bit to sell may be the preferred course.

Ryan Kuhn


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