Value Builder Series: Factor 1 – Financial Performance
One of the eight factors that contribute to your company´s sellability is your financial performance. Specifically, the size of your turnover along with your past and expected profitability.
A financial acquirer sees buying a business as paying today for a stream of profits in the future, which is why companies are generally bought and sold using a multiple of earnings. But focusing on your multiple is a little bit like a hypertensive person focusing on his or her blood pressure report. To really understand the number – and to move it up or down – you have to understand the calculations.
Watch this short video by John Warrillow in which he discusses the importance of having your financial house in order.
The numbers behind your multiple
Buyers acquiring a company will usually do some calculations to determine what they are willing to pay today for the rights to that business´s future profits. We´ve all made a similar calculation. For example, you may have decided in the past to invest R1,000 in a bond that offers 5 percent interest per year; that is, you decided to spend R1,000 on something that would be worth R1,050 a year later.
To see how these calculations affect the value of your business, imagine you have a company that you expect to generate R1,000,000 in pre-tax profit next year. Buyers looking for a 15 percent return on their money in one year would pay R869,570 (R1,000,000 divided by 1.15) today for R1,000,000 a year from now.
When valuing a business, financial buyers will typically value not only the next year´s profit, but all expected profits in the foreseeable future. For every year into the future buyers must wait to get their profits, they will ‘discount’ the future profit you are projecting by the rate of return they expect.
For example, if you project your company will generate R1,000,000 of profit per year for the next 10 years, financial buyers would ‘discount’ the R1,000,000 by 15 percent for each year they have to wait for their money:
|End of year||Pre-tax profit||15% discount|
Therefore, an investor looking for a 15 percent return on his or her money would pay R5,018,780 (in MBA parlance, this is called ‘present value’) today for a business that he or she expects to generate R1,000,000 a year for the next 10 years.
|What was your profit margin (before tax) in your most recent completed financial year? NOTE: Please adjust your profit margin to reflect a market rate salary for the owner(s). For example, if you withdrew R350,000 in compensation but you could hire someone to replace you for R120,000, then estimate what your profit margin would have been if you had only withdrawn R120,000.|
The relationship between risk and return affects your Score
The price an investor is willing to pay for an asset relates to how risky he or she perceives the future stream of profits to be: the riskier the investment, the higher the return an investor will demand. Today, investors can put their money into relatively safe bonds and
get a few percentage points of return, or they can buy a balanced portfolio of bigcompany stocks and expect perhaps a seven or eight percent return over time.
But when buying one relatively risky business rather than a balanced portfolio, investors will expect a much higher return on their money. For illustrative purposes, imagine an investor is looking for a 50 percent return for buying your business because he or she deems your future stream of profits to be very risky. The following table illustrates the effect a 50 percent discount rate has on the value of the business projecting R1,000,000 in profits per year:
|End of year||Pre-tax profit||50% discount|
The same business projected to generate R1,000,000 for the next 10 years is worth less than half as much when, due to perceived risk, the investor demands a return of 50 percent instead of 15 percent.
The relationship between size and risk
Corporate financiers refer to a ‘small company discount’, which often applies because of the perception that very small companies are riskier than larger businesses. It is generally understood that larger businesses are more substantial and stable organisations because they have found a way to grow beyond the efforts of the owner(s) and are therefore less reliant on the owner(s). Because of this perception, the size of your business affects your Sellability Score.
Consider the following questions with your Business Doctor:
- Are you artificially reducing your profits by expensing anything to your business that benefits you personally?
- In what ways could you make your bookkeeping more professional?
- As you look down your list of monthly expenses, is there one thing that could be cut?
- Are you getting the very best pricing from all of your key suppliers today?
What is the next step?
There are 8 factors that drive that value of a business. Complete the Value Builder Survey now to find out your overall score then attend our Business Builder Workshop to find out how you can improve the value of your business.
Set aside 15 minutes to complete the Value Builder Survey.
Why you should do the Value Builder Survey:
Watch this quick video to find out why your Value Builder Score matters.
Credits and notes: The information in this article is by John Warrillow. The Value Builder Score has recently been renamed from Sellability Score to Value Builder Score.
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