Recap of what we’ve learned so far

Given that many Finweek and ValuationUp.com readers will be reading this edition just before the start of the December holidays, we thought it would be useful to re-cap what we’ve learned so far, and set the scene for what it coming in the next months.

We started this column with pointing out that entrepreneurial failure rates are very high, and that for entrepreneurs who get past the crucial first year or two the biggest cause of failure is a ‘lack of financial understanding of the business by the entrepreneur’. Our intention is to make a material impact on success rates by increasing the level of understanding of finance by entrepreneurs.

‘Corporate finance’ as a discipline tries to maximise the value of the firm by (a) investing in assets that earn a return above its hurdle rate, (b) optimising the mix of debt and equity to fund the firm, and (c) returning money to shareholders in the form of dividends or share buy-backs if the firm can’t succeed at (a). The ability to do this depends on treating your business like any other unemotional investment and also on having sound financial information through regular management accounts and audited financials. Reliable data allows rational decision-making.

When valuing a business we try to determine “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts”. This is called its Fair Market Value (FMV).

So how do we actually measure the value of a business? There are 3 broad approaches:

  1. The Asset approach: which measures the value as ‘assets net of liabilities’
  2. The Market approach: which compares the business to other recent transactions of a similar nature, and
  3. The Income approach: which attempts to measure value by converting the stream of expected economic benefits (profit after tax, cash-flows, or dividends) into a single present-day amount.

We debunked the worth of the Asset approach (except in liquidation), and of the Market approach – almost never worthwhile for SMB’s (due to a lack of direct comparables, low trading volumes and dubious financial info).

The Income approach requires some understanding of basic maths and the ability to question the future of the business, however it’s the only method that produces a usable result. If you are still not convinced then think through this statement: “2 firms in the same industry with identical financial statements can face very different futures, and thus have very different valuations.” Only the income approach using a Discounted Cash Flow valuation can measure the impact of the ‘different futures’ to show which of these two firms is more valuable. The other approaches would value them the same, which is obviously a falsehood.

In SMBs, calculating cash flows requires some adjustments (e.g. adding back discretionary spending, excess owners compensation, dealing with once-off losses or gains, non-operating expenses, and periodic losses or gains). These adjustments require some care and objectivity. Costs that are reasonable to the seller are not to the buyer, both need external advice and sharp pencils.

To help use the history of the firm to check assumptions made about its’ future, we introduced the concepts of Compound Annual Growth Rates (CAGR) – by which you can quickly see how much a line item has changed over several financial periods and ‘error-check’ projected growth rates. We showed how to use the ‘Sum of years’ digits’ method to give reliable weightings to the values from different preceding years.

Forecasting growth is always tricky and I’ve no doubt that if you put all the entrepreneurs forecasts together we’d see economic growth of several multiples of national GDP over the next few years. The trick is to be sceptical of any claims over 10% growth; most SMBs operate in very competitive markets where growth is far but assured.

Once we have understood our costs structures and our growth rates, we’re ready to pull that together into a cash flow forecast. To do that, we need to understand the cash-flow formula then simply pull the numbers across (again, early formulas are in prior articles and also eventually reach blog.valuationup.com).

With a cash flow forecast in hand, we introduced the concepts of discounting back to present value, including how to calculate the terminal value of the DCF (the value of the firm for all years beyond 5 years into the future). The question then becomes which discount rate to use, and in the last few articles we’ve unpacked the core concepts of the firms Weighted Average Cost of Capital.

Through this journey, hopefully you’ve understood that as an entrepreneur you need to do a regular DCF valuation of your business to set future targets. Then you need to manage your capital structure and cost of capital closely so that you maximise this valuation. This is one of the core things that big companies do which SMBs don’t, and it’s not too hard.

Now that we have understood what drives valuation and the cost of capital, we can turn our attention to answering the other core questions in corporate finance (a) what projects should be invest in that increase the value of the firm? And (c) when should we declare dividends or buy back shares?

Remember to ask for help if anything here has confused you: @valuationup

Optimal WACC means optimal Valuation

Regular readers will know by now that some basic maths is unavoidable in Finance. Please be assured that it’s my objective to keep this to a minimum here and to make the subject more accessible. A lot of what finance does is around the quantification and pricing of risk and returns – as such there is far more hard-core maths and stats in Finance than is suitable for average reader (but quite fun for those of us who like numbers). If you get stuck on a concept please read back through prior articles or send a message to @valuationup and I’ll try to help:

This column attempts to bring an understanding of the techniques big companies use to maximise their share price (i.e. their valuation) to the world of entrepreneurs and SMBs. The understanding most entrepreneurs lack is around how they can use Corporate Finance principles to maximise the growth and valuation of their businesses, and within this it’s Capital structure where entrepreneurs tend to be weakest still: unlike big companies where capital structure is a key variable that is managed regularly, few entrepreneurs understand it and very few manage it. A lot of value is left on the table and today I’ll try to show you how to figure it out. We’ll be bringing together the DCF valuation using different WACC (Weighted Average Cost of Capital) options as the discount rate. The objective is to see what Capital structure optimises the value of the firm.

Previously, we built up a DCF valuation using the following formula and cash flows:

DCF=(CF1/(1+r)^1)+(CF2/(1+r)^2)+(CF3/(1+r)^3)+{(CF3*(1+g))/(r-g)}/(1+r)^4)

Where CF1 = Cash Flow in year 1, CF2 = Cash flow in year 2 etc, r is the discount rate (i.e. the WACC), and g is the growth rate in % that we predict in the long term.

If we have expected cash flows of R7M, R8.5M, and R10M in each of year 1,2 and 3, a growth rate of 3% and a WACC of 20% then the model works out like this:

DCF=(7/1+20%)+(8.5/(1+20%)^2)+(10/(1+20%)^3)+(60.58/(1+20%)^4)

DCF=46.7M

Now, let’s recap how we build up the formula for the Weighted Average Cost of Capital:

WACC = (E/(E+D))*Ke+(D/(E+D)*Kd)*(1-t)

E=$ value of equity

D=$ value of debt financing

Ke=Desired return (%) on equity

Kd=Interest rate on debt

t= corporate tax rate.

Let’s work through some scenarios.  Assuming a firm needs R10M of capital and the corporate tax rate is 30%.

Scenario All equity 15% debt 30% debt 45% debt 60% debt All debt
Equity: 10 8.5 7 6.5 4 0
ROE: 20% 20% 20% 20% 20% 20%
Debt: 0 1.5 3 4.5 6 10
Interest rates: 12% 15% 18% 23% 27% 35%
WACC: 20% 18.58% 17.78% 18.64% 19.34% 24.5%
Valuation: 46.7M 51.4M 54.4M 51.2M 48.8M 36.2M

 

One can see from the above table that the value of the firm in this example is maximised with a capital structure that has 70% equity and 30% debt. Increasing the debt beyond this increases the cost of capital as lenders charge more to cover the risk of default which goes up as the same cash flows are used to fund (and assets are used to secure) increasing levels of debt.

The quick hack for entrepreneurs without a calculator is to have around 25-35% of your firm funded by debt.

Since banks will always require some form of security around the money they lend to you, which may include cession of debtors, assets and personal sureties, you will have to see a complete proposal from a bank before you consider the optimal level based on your own circumstances. It pays off each time to keep your banker honest by getting proposals from competing banks for your business. A difference of 1% can make several Million Rand difference to your valuation and is worth fighting for.  As an example in real-life, a friend of this column, who runs an inbound safari-touring business with 20 busses managed to get his bank to offer him 1% less on his vehicle finance by simply telling him they were speaking to a competing bank. The difference in interest payments will pay for another bus within just a few years.

We’ll do a quick recap of the lessons learned to date next week, before moving on to look at how to assess the performance of your business and increase its potential over the coming months.