Enhancing value through key drivers
Enhancing the value of your company depends on how well you manage growth, profitability and risk. Growth and profitability naturally have a positive impact on the value, whereas risk has a negative impact. The key drivers, which generate growth and profitability and give rise to risk, vary between companies and industries.
Some key drivers are common and focusing on them can greatly enhance the value of your company.
Diversified customer base
The ability to diversify your customer base and increase your market share will be perceived as a definite advantage by investors. Investors are typically concerned with the concentration of the customer base, as any single large customer is an increased risk from any potential loss of revenue.
Conversely, a large customer base, where each customer contributes a small proportion of total revenue, helps to insulate a company from a huge decline in revenue or profits should the company lose customers. A practical example of a strategic move to diversify the customer base is a Singapore company, which has recently expanded in the South-east Asia region through domestic players that have a credible foothold in their local markets.
This customer diversification enables the company to reduce its risk of over dependence on any single market. At the same time, the entry into the other markets with higher growth rates can improve the overall revenue growth and can lead to profitability improvements through cost savings due to higher volumes.
Recurring revenue streams
Investors look for companies with recurring revenues, that is, revenues that come from strong customer relationships and customer loyalty. This ensures predictable revenue streams and lower earnings volatility. The predictability and low risk of this kind of revenue will be of a higher value than one-off revenues.
Some examples include customers on long term contracts, annual service and maintenance fees, retainers, technology licensing fees and rental income, among others. Any activity that can support or build (profitable) customer recurrence is value adding. A high degree of customer loyalty or recurring revenue leads to lower investment risk, and hence higher value.
Investors put a higher value on a company with unique and diversified product offerings than generic offerings. Companies with a limited and generic product range are generally perceived to have a higher business risk or reduced profitability and investors will hence ascribe a lower value.
When we pointed out to a client that it was overly dependent on a few services, the client began to build up a wider range of engineering capabilities.
Not only was it able to secure new customers, the client is now able to cross-market its services to different customers as well, improving its revenue and profitability while reducing risk.
Barriers to Entry
A company that owns any intellectual property, “hard to get” permits, licences, regulatory approvals or is one of the few qualified suppliers for each of their customers enjoys a lower intensity of competition, higher profitability and lower risk. If your product or service applies or can break through these barriers, your company will be an attractive investment target as the company can leverage on the advantage of access to an exclusive segment of customers or market.
The impact of growth to the valuation is tremendous. Consider a company with a 10% required return on capital and earnings of $1 million. If zero growth in earnings is expected, such a company would be valued at 10.0x earnings. If the company can improve growth to just 2% a year, the company would be valued at 12.5x earnings, an increase of 25% in value. With a 4% per annum growth, the valuation would increase to 16.7x earnings, an increase of 66.7%.
The growth strategy can be driven by several factors such as industry growth, development of new products, increased productivity or increased demand for the company’s products. Your growth strategy needs to be well documented and committed to by management. Reliable forecasts broken into near-term KPI (Key Performance Indicators) that are continuously monitored are extremely useful in tracking that the company is on target and in fostering management accountability.
Capital and cash flow management
Profitability is not just about generating earnings or cash flows. The earnings or cash flows have to be profitable and provide a return to investors. Return on capital involves both the profit and the capital invested to generate the profits. This means that managing the balance sheet, that is, the inventory, receivables and creditors, is as important as managing the profit and loss.
A company that needs lesser assets to operate has a higher return on assets and is valued higher than a company requiring more assets to operate. Managing the balance sheet makes as much sense as managing the profit and loss accounts.
One of the most important value drivers in any company is its people, especially its management team. It is the management team that drives growth, profitability and risk strategy and hence the value of the company.
Retaining, motivating and incentivising the management team is key. It is important to implement incentive compensation, such as stock grants or employee stock options plan aligned to the company's growth, profitability and risk strategy to retain and incentivise key management. A good succession plan to groom talented managers to assume higher positions and ensure that the company is not overly dependent on one or two key managers is also a key area worth considering.
One of our clients successfully implemented an employee share plan for selected employees, awarding them shares in trust under a trust deed. Under the plan, the founders will contribute part of their share holdings to a trust. The shares will then be distributed to these employees after 3 years. The founders' intention is to groom talented managers who can subsequently succeed them. It also acts as an incentive for the employees as they can encash the shares after 3 years.
Illustration of capital and cash flow management
CONSIDER a company that has revenue of $100 million and profits of $3 million. Due to credit terms the company has 45 days of revenue tied up net in working capital (inventories, receivables and creditors).
This company needs investors to provide capital of $12 million (45 days divided by 365 days multiplied by $100 million). The company’s return on capital is 25% (profits of $3 million divided by the capital of $12 million).
If the company is able to improve this to 30 days, the company only needs $8 million (8% of $100 million). The company’s return on assets is 37.5% ($3 million divided by $8 million).
Cash flow is improved by $4 million. To get the same cash flow, the company would have to increase prices by 4% or reduce costs by more than 4%.
Industry leadership can help to enhance a company's value. Participating in awards, encouraging your staff to publish articles and to speak at industry events, promoting the company through local TV or any mention of the company in print or other media will increase the awareness of your company, leading to more business referrals and potentially higher revenue or profitability.
Effective use of professionals
Having financials audited by a reputable CPA firm and embracing good corporate governance are favourable to the company as they reduce the perception of risk. A set of clean books improves confidence and aids the due diligence and negotiation process with potential investors. Unlocking the value of your company is all about how well you manage the growth, profitability and risk of your company. The common factors above can make a significant difference in enhancing the value and it is definitely worthwhile to start thinking about the areas that can be improved now.
Although it is a real challenge to implement, driving your company towards a path of low risk and high profitable growth will be rewarded in terms of the value investors ascribe to your company.
This article was published in The Business Times on the 8 March 2011.