Building long-term value: objective financial analysis focuses clients on business revenue growth.[ILLUSTRATION OMITTED] Privately held companies privately held company A firm whose shares are held within a relatively small circle of owners and are not traded publicly. are often their owners' most significant asset. But when resources are diverted from profitable products to concentrate on short-term revenue, a company's future value may be at stake. This article explains how CPA/ABVs and other valuation professionals can help their business clients stay focused on long-term value creation. CREATING SHAREHOLDER VALUE Value creation relies on two critical components: (1) revenue growth and (2) return on invested capital ("ROIC ROIC Return On Invested Capital ROIC Return On Investment Capital ROIC Readout Integrated Circuit ROIC Resident Officer In Charge ROIC Regional Office Implementation Committee ") in excess of the cost of capital. The cost of capital, which is generally referred to as the weighted average cost of capital Weighted average cost of capital (WACC) Expected return on a portfolio of all a firm's securities. Used as a hurdle rate for capital investment. Often the weighted average of the cost of equity and the cost of debt The weights are determined by the relative proportions of equity CWACC"), is determined by weighting the company's after-tax cost of debt with its cost of equity. ROIC is calculated by dividing the company's after-tax net operating profits Operating profit (or loss) Revenue from a firm's regular activities less costs and expenses and before income deductions. operating profit See operating income. by the sum of working capital and fixed assets fixed assets npl → activo sg fijo fixed assets npl → immobilisations fpl fixed assets fix npl → . Since earning a return in excess of the company's WACC WACC See: Weighted average cost of capital is necessary to increase value, management should understand and use it as a benchmark for strategic decision making. WACC is a combination of the company's cost of debt and cost of equity. The cost of debt is the interest rate the company pays on its long-term debt Long-Term Debt Loans and financial obligations lasting over one year. Notes: For example debts obligations such as bonds and notes which have maturities greater than one year would be considered long-term debt. . Banks and other lending institutions Noun 1. lending institution - a financial institution that makes loans financial institution, financial organisation, financial organization - an institution (public or private) that collects funds (from the public or other institutions) and invests them in charge an interest rate that reflects the risk of nonpayment. The cost of equity is the rate of return necessary to compensate shareholders for their investment in the company. Unfortunately, many business owners often overlook the cost of equity. This is a big mistake from an individual wealth-accumulation perspective. Business owners, just like other investors, have a choice--they can either keep their capital in the company or move it to an alternative investment. If the capital stays invested, its return should reflect the risk of doing so. Since equity returns from investments in privately held companies are not readily observable ob·serv·a·ble adj. 1. Possible to observe: observable phenomena; an observable change in demeanor. See Synonyms at noticeable. 2. , valuation practitioners generally use return data from similar publicly traded companies publicly traded company A company whose shares of common stock are held by the public and are available for purchase by investors. The shares of publicly traded firms are bought and sold on the organized exchanges or in the over-the-counter market. as a proxy. If investors in similar public companies are earning an average annual return of 15%, investors in the privately owned company should probably be earning at least that much or they would be better off investing in the public company. In reality, the proxy rate derived from public company data must be adjusted up or down to reflect the private company's actual risk profile. The following formula is used to calculate the WACC: WACC = [(Dc X (1 - t)) X Wd] + [Ec X We] Where: Dc = Cost of debt t = Marginal tax rate Marginal Tax Rate The amount of tax paid on an additional dollar of income. As income rises, so does the tax rate. Notes: Many believe this discourages business investment because you are taking away the incentive to work harder. Wd = Weight of debt (percentage of the capital structure represented by long-term debt) Ec = Cost of equity We = Weight of equity (percentage of the capital structure represented by equity) For illustration purposes, assume a capital structure of 60% equity and 40% debt (at market weights) and the following costs: Dc = 6% t = 40% Ec = 18% Using the above inputs, the company's WACC is calculated as follows: WACC = [6% X (1 - 40%) X 40%1 + [18% X 60%] WACC = 12.24% For decision-making purposes, management should view 12.24% as a minimum return threshold. To increase the company's value, revenues must grow and produce a net return greater than 12.24%. Returns below the threshold will diminish the company's value. REDUCING WACC From a value-creation standpoint, the lower the company's WACC, the better. More value is created by a lower WACC because of the resulting increased spread between it and the ROIC. The most effective ways to reduce the WACC are to: (1) lower the cost of equity or (2) change the capital structure to include more debt. Since the cost of equity reflects the risk associated with generating future net cash flow, lowering the company's risk characteristics will also lower this cost. If the company depends upon a small number of customers for a significant percentage of its revenues, better diversification of the customer base would lower that risk factor. Likewise, if the company is highly dependent upon one or a few key employees, transferring responsibilities to additional qualified personnel will help reduce that risk. Many business owners try their best to avoid long-term debt. This no or ultra-low debt policy can hamper the company's growth and value-creation potential. Since the after-tax cost of debt is generally much less than the cost of equity, changing the capital structure to include more debt will also reduce the WACC. Using the same inputs as above, the following illustrates how the WACC can be reduced substantially by changing the capital structure from 40% to 60% debt: WACC = [6% x (1-40%) x 60%] + [18% x 40%] WACC = 9.36% The reduced WACC creates more spread between it and the ROIC. This will help the company's value grow much faster. However, adding debt to the capital structure to reduce the WACC only works to a certain point, since too much debt can actually increase risk and constrain con·strain tr.v. con·strained, con·strain·ing, con·strains 1. To compel by physical, moral, or circumstantial force; oblige: felt constrained to object. See Synonyms at force. 2. the company's ability to generate net cash flow. When determining the optimum level of debt for a private company, good proxies to consider are the capital structures of similar public companies. KEY ISSUES Growth in revenues and cash flows as well as achieving a ROIC that exceeds the WACC are critical ingredients for increasing shareholder value. [ILLUSTRATION OMITTED] Top-Line Revenue Growth. Although a company may improve its cash flow in the short term through cost reductions, this strategy has obvious long-term limitations. Therefore, top-line revenue growth is necessary to increase shareholder value. The 80/20 rule of thumb applies to most companies. This means that 80% of gross profit is generated by 20% of the products and services and 20% of the customers produce 80% of the revenues. Analyzing the business with this rule in mind often uncovers opportunities to increase the company's growth and profitability. It helps management focus on areas most likely to optimize cash flow. Determining which products/services and customers have the most potential for helping the company achieve its growth and profitability goals requires: * Analyzing historical sales and gross profit by product/service line. * Determining which customers or types of customers are the most profitable (net of selling and service-related costs). * Assessing industry trends including current and future substitute products and services. * Determining the impact on working capital for each of the significant product lines and customers. Cash Flow. Positive cash flow is necessary to fund daily operating expenses Operating expenses The amount paid for asset maintenance or the cost of doing business, excluding depreciation. Earnings are distributed after operating expenses are deducted. , future growth initiatives and distributions to investors. Therefore, the ability to generate positive cash flow, on a long-term, sustainable basis, is critically important to a business's value. To assess the sustainability of future cash flows, examine how the company reinvests into the business. Companies that consistently reinvest re·in·vest tr.v. re·in·vest·ed, re·in·vest·ing, re·in·vests To invest (capital or earnings) again, especially to invest (income from securities or funds) in additional shares. a significant portion of operating cash flow Operating cash flow Earnings before depreciation minus taxes. Measures the cash generated from operations, not counting capital spending or working capital requirements. into recruiting and training high-quality employees, acquiring new technologies, and funding research and development initiatives will most likely have higher growth rates Growth Rates The compounded annualized rate of growth of a company's revenues, earnings, dividends, or other figures. Notes: Remember, historically high growth rates don't always mean a high rate of growth looking into the future. and be more profitable on a long-term, sustainable basis than those that do not. A company's reinvestment Reinvestment Using dividends, interest and capital gains earned in an investment or mutual fund to purchase additional shares or units, rather than receiving the distributions in cash. 1. In terms of stocks, it is the reinvestment of dividends to purchase additional shares. efforts are illustrated through the ratio of annual investments in new operating assets Operating Assets Another term for working capital. to available operating cash flow. Available operating cash flow equals after-tax net cash flow from operations Cash flow from operations A firm's net cash inflow resulting directly from its regular operations (disregarding extraordinary items such as the sale of fixed assets or transaction costs associated with issuing securities), calculated as the sum of net income plus noncash expenses before reinvestments. The higher the ratio, the better the investments are paying off. If the ratio is trending down from year to year, management should re-evaluate its investment decisions. One of the best ways to grow cash flow on a long-term, sustainable basis is by increasing the volume of units sold and decreasing the related cost per unit. Higher volumes result in lower unit costs due to improved operating efficiencies and better utilization of resources (that is, spreading fixed costs fixed costs, n.pl the costs that do not change to meet fluctuations in enrollment or in use of services (e.g., salaries, rent, business license fees, and depreciation). over more units). To achieve higher unit sales unit sales Sales measured in terms of physical units rather than dollars. Unit sales data are often used by financial analysts when evaluating the health of a company. volumes, a company can narrow its product/service offerings and focus on what it does best--that is, it should not try to be all things to all potential customers. EXECUTIVE SUMMARY * To maximize the long-term financial performance and value of a business, CPAs should help management focus on two key components of value creation: revenue growth and achieving a return on invested capital (ROIC) in excess of the weighted average cost of capital (WACC). * A lower WACC creates higher value because of the resulting increased spread between it and the ROIC. * CPAs can use three tools to measure and monitor a company's performance: * DCF DCF See: Discounted Cash Flows . A discounted cash flow analysis quantifies the present value of expected future net cash flow using the WACC. * EVA Eva to marry winner of singing contest. [Ger. Opera: Wagner, Meistersinger, Westerman, 225–228] See : Prize 1. Eva - A toy ALGOL-like language used in "Formal Specification of Programming Languages: A Panoramic Primer", F.G. . An economic value added Economic value added (EVA) A method of performance evaluation that adjusts accounting performance for investors' required return on investment. Suppose a division produces a 12% return on capital invested. analysis reveals the return in excess of the company's cost of capital by subtracting a capital charge (invested capital X WACC) from the company's net operating profit after taxes (NOPAT NOPAT Net Operating Profit After Tax ). * Performance-based compensation plans. Such plans motivate employees and align their interests with those of the owners. Tools for Creating and Measuring Value The following tools are often used by consultants to measure, monitor and enhance a company's value-creation progress: Discounted cash flow (DCF) analysis. A DCF analysis measures a company's value by quantifying the present value of its expected future net cash flow using WACC as the discount rote rote 1 n. 1. A memorizing process using routine or repetition, often without full attention or comprehension: learn by rote. 2. Mechanical routine. . For this purpose, net cash flow is defined as after-tax cash flow from operations on an invested capital basis (excluding the impact of debt service) less the sum of net changes in working capital and new investments in capital assets capital assets n. equipment, property, and funds owned by a business. (See: capital, capital account) . The DCF formula is as follows: Value = [[CF.sub.1] / [(l + r).sup.1]] + [[CF.sub.2] / [(l + r).sup.2]] + ... + [[CF.sub.n] / [(l + r).sup.n]] Where: [CF.sub.1] = net cash flow in year 1 [CF.sub.2] = net cash flow in year 2 [CF.sub.n] = net cash flow in year n r = discount rate (WACC) The company's net cash flows are projected for a number of years and then discounted to present value using the WACC. The expected cash flows earned beyond the projection period are capitalized into a terminal value and added to the value of the projected cash flows for a total value indication. The DCF model relies upon cash flow assumptions such as revenue growth rates, operating margins Operating Margin A ratio used to measure a company's pricing strategy and operating efficiency. Calculated by: , working capital needs and new investments in fixed assets for purposes of estimating future cash flows. After establishing the current (baseline) value, the DCF model can be used to measure the value-creation impact of various assumption changes. Performing these "what-if" scenarios with management is an effective way to motivate the implementation of needed changes. For example, if the baseline model assumed a revenue growth rate of 10% and a gross profit margin Gross profit margin Gross profit divided by sales, which is equal to each sales dollar left over after paying for the cost of goods sold. gross profit margin A measure calculated by dividing gross profit by net sales. of 40% for the next five years, management can easily see the benefit of increasing the revenue growth rate to 15% and improving the gross profit margin to 45%. Finding the best opportunities for making these improvements requires analysis (see above), but the benefits are worth the effort. Economic value added (EVA). Based on the premise that shareholder value is created by earning a return in excess of the company's cost of capital, EVA is calculated by subtracting a capital charge (invested capital x WACC) from the company's net operating profit after taxes (NOPAT). If the EVA is positive, shareholder value has increased. Therefore, increasing the company's future EVA is key to creating shareholder value. An EVA model normally includes an analysis of the company's historical EVA performance and projected future EVA under various assumptions. By changing the assumptions, such as for revenue growth and operating margins, management can see the effects of certain value improvement initiatives. For illustration purposes, assume the following simplified facts: NOPAT = $15,000 Invested capital = $50,000 WACC = 12% EVA = NOPAT - (Invested capital x WACC) = $15,000 - ($50,000 x 12%) = $9,000 The example above indicates that both operating and capital charges have been covered and shareholder value has increased by $9,000. Performance-based compensation. This effective tool for motivating employees aligns their interests with the shareholders. For example, establish a base level of compensation plus a bonus pool tied to certain EVA targets. A minimum level of EVA is required for any bonus to apply, and the pool increases based on how much actual EVA exceeds the minimum threshold. By tying compensation to certain performance metrics Performance metrics are measures of an organizations activities and performance. Performance metrics should support a range of stakeholder needs from customers, shareholders to employees [1]. , such as EVA or EVA improvement, employees have a sense of ownership and strong incentives to help achieve the company's value-creation goals. Numerous criteria and performance metrics can be used in setting up a performance-based compensation plan. However, to be effective, the performance criteria must be achievable, measurable and clearly communicated to the employee(s) intended to be impacted by it. Regular feedback and information reporting procedures should be established that will help employees monitor their progress for meeting the performance goals throughout the year. Tapping a Fresh Stream of Profits Our firm was engaged to analyze a wholesale drink distributor's financial performance and assist with formulating a plan to grow revenue and shareholder value. The company was a small family-owned business that had suffered from low profitability over the previous several years. Using a DCF model, we quantified the potential impact of our recommendations. Our financial analysis started with a year-to-year comparison of the company's historical financial statement data, We also benchmarked the historical data against industry peers. This type of comparison is generally useful for identifying potential problem areas and narrowing the initial focus. Our analysis indicated the following issues: 1. Revenue growth was very low at approximately 5% per year over the previous five years. 2. Gross profit as a percentage of sales was stable and in line with the industry peer group. 3. Operating expenses as a percentage of sales were substantially greater than the industry peer group--primarily due to a high level of fixed expenses. 4. Working capital was substantially above the industry peer group--primarily due to low inventory turnover. After entering the historical financials into our DCF model, we estimated the company's future net cash flows and value based on its current level of performance. The value indication, much lower than the owner expected, was then used as a benchmark for measuring the impact of our improvement recommendations. After analyzing the company's operations and revenues by product line and customer, we identified several opportunities for improving revenue growth and profitability: * Increase sales and marketing efforts in two nearby cities with excellent growth potential where the competition was less vibrant. As an initial step, hire a new sales manager sales manager n → gerente m/f de ventas sales manager n → directeur commercial sales manager sale n → dedicated to this effort. * Eliminate several slow-moving product lines with low upside potential Upside potential The amount by which analysts or investors expect the price of a security may increase. upside potential The potential price or gain that may be expected in a security or in a security average, generally stated as the dollar . The upside potential of the lines was insufficient relative to the sales resources being utilized. * Increase inventory turnover by reducing the level of slow-moving products and improving the purchasing and inventory management systems. * Develop a formal marketing plan and update the company Web site to allow customers the convenience of placing orders online. * Change the compensation terms for all management-level employees to a base-plus-bonus plan with the bonus tied to predetermined pre·de·ter·mine v. pre·de·ter·mined, pre·de·ter·min·ing, pre·de·ter·mines v.tr. 1. To determine, decide, or establish in advance: profitability targets. * Reduce operating expenses as a percentage of sales from 25% to 20% over the next five years as revenues increase. Based on our discussions with management and research regarding the company's competitors and industry, we concluded that revenue growth of 15% to 20% per year over the next five years should be achievable. By updating the assumptions in our DCF model to reflect the above changes, we were able to illustrate the potential impact to management. If management could successfully accomplish the above goals, the net result would be an increase in value at the end of five years of approximately three times the non-improved value. The company is currently in the seventh month of implementation and appears well on track to meeting the targets. W. James Lloyd James Lloyd may refer to:
abbr. Master of Business Administration Noun 1. MBA - a master's degree in business Master in Business, Master in Business Administration , is an analyst with ValuePoint Consulting Group, Knoxville, Tenn. ValuePoint provides valuation, value improvement and litigation An action brought in court to enforce a particular right. The act or process of bringing a lawsuit in and of itself; a judicial contest; any dispute. When a person begins a civil lawsuit, the person enters into a process called litigation. consulting services Noun 1. consulting service - service provided by a professional advisor (e.g., a lawyer or doctor or CPA etc.) service - work done by one person or group that benefits another; "budget separately for goods and services" , www.valuepointconsulting.com. |
|
||||||||||||||||
Printer friendly
Cite/link
Email
Feedback
Reader Opinion