The 3 Value Levers – Earnings, Growth, and Risk

The single greatest reason most owners fail to exit successfully is that their business isn’t worth enough. Why does this happen? The answer is quite simple. Too many owners simply don’t understand the fundamentals of what drives value in a business, i.e., what buyers are looking for when they buy a business.

What Are Buyers Looking for in a Business?

  1. Buyers are looking for a steady, repeatable stream of income. They are also looking for future earnings potential.
  2. Buyers are looking for proof that the firm has consistently grown and evidence that it will continue to grow in the future.
  3. Buyers discount what they’ll pay for a business based on risk. A risk that growth will go off track or that repeatable income stream will shrink or disappear. Often, that risk is company-specific and is in your control.

3 Fundamental Variables Drive Value

In short, buyers are looking for:

  • Earnings,
  • Growth, and
  • Risk.

All our valuation formulas stem from these three simple variables. If you understand these variables and drill down on them in your company, not only can you start to understand valuation, but significantly you can improve the value you can derive for your business at the exit. Let’s look at each individually.

Related: Valuation Basics – Earnings, Growth, Risk. 

Earnings

Buyers are looking to get a steady stream of positive returns on their investment in the form of repeatable earnings. They consider volatility in the earnings as a sign of less certainty to stable returns.

In this regard, a private company is no different than a public one. The value of a stock is a multiple on earnings; usually, the greater the earnings, the greater the price. Businesses point to record years as benchmarks of what kind of earning they are capable of generating.

So it’s not a surprise that companies that demonstrate consistently high past earnings performance command a premium to the prevailing average market EBITDA multiple. On the other hand, organizations having ordinary or decreasing earnings get a lower-than-average market multiple.

Buyers are also looking for the earnings potential of the business. While exhibiting positive historical earnings patterns is excellent for business owners, investors base enterprise value on the forward-looking returns they expect to receive. They’re looking for future earnings potential – opportunities to increase future earnings.

Growth

Buyers want to know how the business has grown in the past. It’s because a company with a track record of successful past growth sends signals to buyers that continued growth is much more likely.

Buyers also need evidence that the organization will continue to grow in the future. Buyers are often willing to pay more for a business situated in a high-growth market or for a company that has proven its ability to grow faster than its peers in a market.

But, they’re also looking at a company’s unique capabilities and how they relate to future growth potential. They often award a premium to a company with unique competitive advantages such as differentiated products or services, proprietary processes, intellectual property, enhanced production capabilities, unique distribution channels, etc.

Do you have a clear and coherent business plan that describes how the company will continue to grow into the future? Have you established specific long-term growth goals and articulated how you’ll get there. Have you accounted for competition, emerging technologies, growth opportunities, and unforeseen risks?

You don’t have to have all the answers. But, a clear strategic vision coupled with a plan to get there signals a buyer that historic growth can and will continue after the most valuable employee leaves (likely you).

Risk

While buyers value a business based on its past, present, and perceived future earnings and its track record of past growth and potential for future growth, all types of risks could disrupt a company’s future profits and growth potential. And obviously, COVID-19 was a largely unforeseen risk that affected everyone in one way or another.

Here we’re looking at company-specific risks such as owner dependence, client concentration, flight risk of senior executives, dependence on key employees without contracts to keep them in place, lack of effective processes, etc.

Owners are often blind to these risks or grossly underestimate their impact. The risks impacting business value include:

Customer Concentration

Customer concentration is when a single customer is responsible for more than 20% of annual sales, or any three customers generate over 50% of yearly sales. Companies with significant customer concentration often receive lower than average EBITDA multiples over organizations from the same industry, having equivalent revenues and profitability but a more diverse customer base.

You can minimize the negative impact of customer concentration on business value by having long-term agreements with large customers or becoming a sole source supplier of the products you provide.

Industry Concentration

Organizations having their revenues concentrated within a specific end market are highly vulnerable to the impact of sector-specific variables. Companies solely serving the transportation, hospitality, or leisure industries can attest to this coming out of the pandemic.

However, in some cases, industry concentration can have a positive effect. For example, a business serving a high growth end market may attract a premium earnings multiple.

Management Strength and Depth

Smaller companies are usually dependent on their owners’ entrepreneurial talent as they are responsible for one or more critical functional areas. However, over-reliance on a single person increases business risk. The market assigns a higher value to a company with a complete management team with different talented individuals leading the critical functional areas of Engineering, Sales and Marketing, Operations, Finance, etc.

Effective Operations

Strategically aligned operations and processes increase an organization’s ability to achieve and sustain performance. Companies with poor operational discipline often struggle to react to changing buying patterns, customer needs, or emerging competitors.

On the other hand, high-performing organizations have well-documented processes, operational discipline, highly flexible operations, the ability to adapt to the changing environment to seize revenue and growth opportunities. Frequently, strong operators attract premium valuations.

Closing Thoughts

Quite often, entrepreneurs simply don’t understand what their business is worth. They’re surprised (not in a good way) when they find out what their business is really worth and the reasons it’s not worth as much as they’d like. Frequently, they can drive value years in advance of an exit. They simply don’t know how to do so.

Start by understanding the fundamentals of what drives value – Earnings, Growth, and Risk. By recognizing and assessing them in your company’s context, you can identify areas needing improvement, develop realistic value expectations, plan actionable value acceleration initiatives, and achieve your desired exit.

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Author Summary:
Dan Doran

Dan Doran

Is the Founder of Value Scout, Quantive and the 2019 Exit Planner of the Year. He is a recognized expert and speaks frequently about M&A, valuations, and developing more deliberate value creation strategies.

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