BUSINESS TALK

What drives business value?

To understand the drivers of value we need to understand what value is and why it is important? Every entrepreneur is in business to make money, but how do we measure "making money"?

Making money is measured in 3 ways:

  1. by generating Net Profit, and
  2. by turning net profit into Cash Profit, and
  3. by making an acceptable Return on Equity (ROE)

Net Profit is normally a familiar concept, but Cash Profit (i.e. what happened to your bank balance?) is sometimes confusing. The difference between Net Profit and Cash Profit can however be explained by the monthly (or annual) change in one of the following i.e. depreciation, capital expenditure, increase or decrease in stock, debtors and/or creditors. Although making a Net Profit is important, making a Cash Profit is more important because it pays the bills.

If a business is generating a Net Profit and a Cash Profit it is all good and well, but unless the business is making an acceptable return on equity investors will not be interested in the business and consequently the value of the business will be limited to its net asset value (Assets less Liabilities).

Return on equity is calculated as follows i.e. Return (Net profit after taxation) divided by Equity (Assets less Liabilities = Net Assets)*100. For privately owned businesses we would like the ROE to be higher than 25% to compensate investors for the investment risk that they take. A 25% ROE is equal to a 4 times price earnings ratio and means that the investor values the business at 4 times the annual earnings of the business. Listed companies generally have a much higher price earnings ratio than privately owned companies due to the fact that listed shares are more liquid and tradable. In addition listed companies have more mature systems, processes and people disciplines that "protects" earnings for longer than what is traditionally the case in private companies.

Net Profit, Cash Profit and Return on Equity (i.e. the hard measurables) are positively impacted by the following drivers of value:

  1. A market with sufficient demand for your product
  2. A quality product that has a competitive value proposition that it can sustain
  3. Good gross profit and net profit margins
  4. Operational processes that ensure internal and external activities are of a high quality and are cost effective
  5. Competent people supported by good people practices that supports an innovative, friendly and efficient service experience for clients
  6. A brand that embodies trust and builds long term client loyalty
  7. A balance sheet that is efficiently and effectively structured and can support the funding requirements of the business in the short, medium and long term.

The value of a business is therefore driven by a combination of hard (i.e. financial) and soft (i.e. non financial) issues. The soft issues are commonly referred to as intangible assets and represent the goodwill that investors are prepared to pay for over and above the net asset value of the company. Investors will only be prepared to pay for goodwill if they believe future cash earnings are predictable and of a high quality. The latter is only achievable if business owners can convince potential shareholders that the drivers of value within the business are sound and sustainable and that management succession planning is in place.

I tried to simplify the topic, but it remains complex if you are not familiar with company valuations. If you need advice on how to protect, build and/or grow the value of your business please do not hesitate to contact me on 021 912 4000 or at alwyn@marathongroup.co.za.

Alwyn Rossouw
Marathon Group