Many business owners only think of getting their businesses ready to sell when they’re ready to sell. At this point it’s too late. In today’s guest post, Stephen D. Hassett explains why a history of top and bottom line growth are the keys for driving value.
You’ve spent years building your business and you are ready sell it. How do you maximize value? Unfortunately, you may be too late. The value creation process needed to start years ago, and short-term fixes may actually make things worse.
To maximize value you want to have sustainable growth and strong cash flow (earnings). It’s that simple. Instead, many people believe the market is almost arbitrary in assigning values. This leads to bad decision making.
One of the main metrics used to compare values between companies is the P/E ratio, which is simply the value of a company divided by its earnings, or the share price divided by its earnings per share. If Company A earns $1.50 per share and its stock price is $15.00, then its P/E ratio is 10. If Company B’s stock price is $30 with the same $1.50 in earnings, then its P/E ratio is 20. This implies that for every 10 cents per share that Company A adds it will increase its share price by $1.50, while Company B’s will increase by $3.00. Obviously you want a high P/E ratio, but how? Why aren’t all dollars the same? Why do some companies command a premium?
To answer these questions and understand what drives P/E ratios it helps to look at the stock market as a whole. The P/E ratio of the stock market can be explained by a very simple formula: P/E = 1 divided by cost of capital less growth or P/E = 1 / (C – G). (If you want to understand why this simple formula works you can read my book, The Risk Premium Factor.)
This formula tells us some very interesting things. Most importantly – if your growth rate increases so does your P/E ratio and your company becomes more valuable. For example, let’s say your cost of capital (investors’ expected return) is 10 percent. If your expected long term growth rate is zero, then your P/E ratio is 1/(10 percent – 0 percent) or 10. If you increase your growth rate to 5 percent, your P/E ratio jumps to 20 and the value of your company doubles. It’s that simple: Higher growth means higher P/E and higher value.
Before going any further, it helps to understand what this growth rate means. It is the expected long-term growth in earnings or cash flow, meaning that on average your investor expects the company to grow at this rate forever. Many entrepreneurs don’t grasp that the growth rate is based on investors’ long-term expectations for the future, not on what you did last year and not on what you expect to do next year. Misunderstanding this can cause serious problems.
If you have grown earnings over the past several years by cutting cost and not growing revenue, investors are not going to be convinced you have a long-term growth story because you can’t cut costs forever. In order to have a good growth story, you need to show the ability to grow the top line and the bottom line.
If you want to show bottom line growth by beginning to cut costs a year or two before you’re ready to sell, rather than creating a growth story, you many destroy value by making decisions that sap your top line growth. Here’s how.
Let’s assume your business has been growing at a modest 5 percent per year and earns $1 million. If a would-be buyer believed that you could sustain that growth, we could expect them to pay you 20 times earnings (1 / 10 percent – 5 percent) or $20 million. Rather than take the $20 million, you decide to boost earnings by cutting sales expense by $500,000 and the result boosts your bottom line at the expense of revenue growth, which drops to zero. The savvy investor will see that you have a healthy $1.5 million in earnings but no growth. Since you can’t cut costs forever, they may assume your long-term growth rate is zero. The result is that your P/E ratio drops to 10 (1 / (10 percent – 0 percent), so the value of your business actually drops to $15 million despite the increase in profits.
Not only do investors value growth, but they are smart. M&A professionals know the difference between sustainable and unsustainable growth. Simple common sense says the best way to create that growth story is to start early and invest wisely. Less wide known is the fact that your growth story is one of the most important drivers of value.
Stephen D. Hassett is a corporate development executive with Sage North America, a subsidiary of The Sage Group plc, a leading global supplier of business management software and services. He is author of “The Risk Premium Factor: A New Model for Understanding the Volatile Forces That Drive Stock Prices”.