The value of the company is in the eye of beholder. Investors should carefully evaluate information they can obtain about the company in order to develop expectation of current and future value.
The value of a company is determined by both internal factors, which are subject to the control of management, and external factors, which are out of the control of a company. The reason for, sometimes, wide range in value estimates by various investors is the knowledge about the key value drivers.
HERE ARE KEY FACTORS THAT INFLUENCE THE VALUATION:
Investors should evaluate company’s value drivers by com- paring them to industry peers. For example, one can start with historical price-to-EBITDA multiples as follows:
Why, then, are there such huge differences in value and multiples paid? Profitability, Risk and Growth drive the differences.
PROFITABILITY. All else being equal, more profitable companies are more attractive to buyers and often command higher multiples.
GROWTH. All else being equal, companies that demonstrate stronger growth trends are more attractive to buyers and often command higher multiples. One has to be careful. The growth needs to be profitable, i.e. additional revenue needs to be generating similar level of profit. Notice what happened to Amazon when it announced higher revenue but even lower than expected profit. The stock price dropped over 10%.
RISK. The higher the risk the lower the multiples and thus the value. Here are some typical factors that contribute to risk for a company:
• Market analysis – barriers to entry? Positioning/ differentiation? Market share?
• Management – depth? Age and amount of experience in industry and company? Succession plan? Key man insurance?
• Customers – concentration? Is the revenue recurring or non-recurring from the existing customers?
• Vendors – concentration? Contract terms?
• Lack of product, market, industry, or geographic diversification
• Financial position / strength of balance sheet – What is current capitalization (debt and equity)? What is Net Working Capital requirement?
• IP/Legal risks – Is IP patent protected? Are trade-marks registered? Are there any existing or pending lawsuits? Any regulatory exposure?
• Infrastructure – Are there any required or deferred capital expenditures? Quality of IT infrastructure?
• Internal controls – are there third party audited or review financial statements? What is the spending approval process?
Once the above data is gather for the target company, investors can develop their own initial valuation range. As new information becomes available thru due diligence process the range may change or narrow.
The above process can also be used to project future value. The chart below shows current and potential future value for a sample company. In this case, the investors are counting on the company to increase profitability and reduce certain risks. These two changes would justify increasing the multiple for the business (based on transaction for similar companies). Higher profitability increases the value of the business as well.