Keys to Understanding Your Company’s Value Drivers

As an owner of a privately held business, you have significant personal wealth already invested in your company. When reviewing the annual returns your business delivers, it’s easy to calculate returns based on the book value of the company. For example, book value of $4 million and pre-tax earnings of $1 million generates an attractive 25% return. However, you certainly wouldn’t sell your company for book value, so the returns on the “investment” you have in your private business should be based on market value. (Market value of $20 million with the same $1 million of earnings generates a less impressive 5% return.)

The financial analysis you expect your broker to perform on an investment in publicly traded companies is the same in-depth financial analysis and scrutiny of industry comparables you should perform on your company in which you have millions invested! Benchmarking, or a diagnostic valuation, helps you gain a much better understanding of current performance and future possibilities and the value drivers in your company.

For example, your company, ABC, Inc. is a successful 40-year-old, mid-size specialty manufacturer of jet engine components.  Since you first developed the business, ABC, Inc. has outperformed competitors’ profit margins.  Analysis of the current balance sheet reflects a high net working capital ratio of 2.5 to 1 compared to that of its peers, 1.6 to 1. That looks pretty good, at least on the surface…. but don’t stop there.

Drilling deeper into the calculation of the net working capital ratio reveals the following:

  • The average days in accounts receivable is significantly higher than its peers by almost six days.
  • The number of days of inventory exceeds the industry average by over seven days.
  • Its cash conversion cycle is seven days longer.

By bringing ABC, Inc.’s net working capital metrics in line with industry standards, you learn you could have increased ABC, Inc.’s cash position by over $2MM. What could you do with the extra cash? You might buy more equipment, increase dividends, pay off debt, open a new branch, buy a competitor, etc.

Such an exercise can answer questions like:

  • How can I improve profitability in a down economy or for that matter, in any economy?
  • What are the top three things I can do to raise the value of my business when I do want to sell?
  • Are there opportunities to generate cash by simply running my business more efficiently?
  • Can I consolidate market share through organic growth or acquisition when market values are down?

This type of detailed financial review of your company is not an end in itself, but it will provide information that will help you make sound investment decisions regarding one of the largest assets in your portfolio, your company.

2014 IBISWorld report, "Business Valuation Firms in the U.S."
2017 Private Capital Markets Report,  "Investment Banker Survey"

If you have comments or questions about this article, or would like more information on this subject matter, please contact us.

Will Stewart

 

Michael Poole, Shareholder

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