The value of your business is calculated from 2 things: risk and return.
Returns can be forecast into the future – with some good modelling skills one can build a financial model that projects the likely growth of the firm into the future within ranges that are reasonably certain. My general approach to building a model is to work from the target customer first: understanding the market size, how it will be reached with what budget, then understanding actual customer behaviour in response to marketing and sales efforts. Through this we get to understand how much revenue happens when. Once you have the revenue line it’s relatively easy to work out Cost of Sales, operational expenses, profitability and then balance sheet effects – all of which distil down to the Free Cash Flow calculations a proper valuation model uses.
Risk is really the risk to the capital used by the business. In previous columns we’ve discussed the Weighted Average Cost of Capital (WACC) in some detail; the core concept is that each business has a mix of debt and equity capital that can be optimised. Equity costs more because it carries more risk; debt costs less because it’s typically secured by assets and gets paid out first if things go wrong. The trick is in reducing risk so that you can use more debt and thus reduce the overall cost of capital. The WACC is what’s used to discount the future earnings of the business to arrive at the present day valuation of the business.
How do you create long-term value? Simply put you need to grow free cash flows at a rate faster than your WACC. In other words, you need to grow returns faster than they’re discounted by the perceived risk to the capital used to create those returns.
I’ll use 2 different scenarios from our demo business on ValuationUp.com to illustrate how value is created or destroyed when free cash flows grow faster or slower than a firm’s WACC:
The first scenario is called ‘Run-away train’ and here the firms value grows from a baseline valuation of R13,7M (the red column on the left) to R38,5M (the green column on the right). To achieve this, the business must apply resources to a number of projects, each of which contributes differently to free cash flows and thus to valuation. For this business, the biggest wins come from reducing Cost of Sales, reducing Operational expenses, and in improving working capital management (which together give the business an extra R19M of valuation improvement and an extra R9M of free cash flows in year 1 alone). Contrast this to sales (the gold-coloured blocks in the graph), where growing the business at a steadily ambitious rate of 10% a year raises its value by only R6M with an almost negligible increase in free cash flows in year 1.
In the second scenario “Slow coach”, all variables are exactly the same except sales growth, which is set at 5% for all 5 years rather than the 10% used in the ‘Run-away train’ scenario above. It’s lower than the initial 8.2% used in the baseline valuation calculations, so sales achieving sales of only 5% immediately causes a drop in valuation by nearly R5M in year 1, and slower than forecast growth reduces the company valuation by a further R1.2M over the next 5 years.
The effect of this lower sales growth is that free cash flows in years 2-5 grow lower than the risk to the capital used to generate them (the WACC for this business is 18% in all scenarios). When your free cash flow growth rate (not the revenue growth rate) is lower than the Weighted Average Cost of Capital then value is destroyed over time, which is exactly what is shown the graph of the “Slow coach” scenario.
This difference between these scenarios is R12M of valuation – all of which comes down to whether the firm can grow at 10% or only 5%. The other R19M of valuation improvement comes entirely from operational measures that are far more controllable for most firms, and thus make a better bet as to where to focus efforts when growing the business.