My Stock Portfolio Just Lost a Third of its Value … Did My Company, Also?

The COVID-19 pandemic has ushered in huge market volatility, with stocks and indexes experiencing wild daily and even hourly swings. The breakneck speed of these movements is unprecedented. On March 23, 2020, the Dow Jones Industrial Average closed at 18,592 – down 37% from its all-time high just 40 days prior. This unsettling situation is prompting many private business owners to ask questions about the value of their businesses, and what the public market may imply about M&A-related valuations. This article addresses those questions.

Key Takeaways

• Value is driven by a company’s ability to generate cash flow.
• Valuation multiples are a shortcut to quickly convey valuation information, but they rarely tell the full story.
• While markets go through periods of volatility, the elements of fundamental value don’t change.

The first question we often get from business owners interested in a sale, acquisition or other ownership-related transaction is: What is my business worth? In the context of M&A, the response is blunt: The value of a business is what a buyer is willing to pay.

But unlike publicly traded companies, private business owners don’t have a myriad of buyers providing daily valuation feedback in the form of stock prices. So how do private business owners make informed decisions about undertaking a capital transaction? Rules of thumb and valuation multiples abound, but their rationale and how they apply can be unclear. So, our response to the question is: Tell us about the drivers of your company’s value.

Future Earning Potential – The Intrinsic Value of a Business

The value of any business can be summed up as its potential to generate future cash flow. In other words, it is the company’s ability to generate sales and convert those sales into cash profits. Some of the most critical drivers of cash earnings are:

• The desirability and differentiation of a company’s products or services
• Market size and potential
• Margins and cost structure
• Operating efficiency and conversion of sales to cash
• Capital investment requirements

A company’s valuation also is driven by its growth prospects – its ability to increase cash flow. Frequently overlooked in a value assessment are the risks that threaten profitable operation or growth, and the company’s ability to mitigate risk.

Each of these factors is important for owners and advisors to identify and articulate in order to maximize valuation.

Supply and Demand – Market Effects on Value

Market forces also play a significant role, particularly in the context of M&A. Like other assets, price is determined where supply and demand intersect. These considerations include:

• The number and kinds of buyers seeking to purchase a certain type of business
• The buyer’s expected return on investment
• The effects of an ownership change on earnings and growth
• The ability of the company’s advisor to uncover other potential or non-traditional buyers and market the company to best showcase its strengths

The supply impact can be boiled down to the alternatives that are available to buyers. Competing or similar businesses may be acquired. There also may be other, unrelated investment opportunities. A good advisor is adept at differentiating a business from other investment alternatives.

What About Multiples?

Multiples are a short-cut to conveying valuation information. Most common are multiples of revenue and EBITDA (earnings before interest, taxes, depreciation and amortization). Other metrics are based on owners’ cash flow or free cash flow. Yet others are based on operating statistics, such as users, subscribers, or employees. These metrics serve a similar purpose to the P/E Ratio frequently used to describe valuation of public companies.

A multiple is a common way to communicate valuation since it allows for comparison of companies based on a proxy for cash flow (such as EBITDA). Other drivers like growth, capital efficiency and risk are reflected in a simplistic way by the multiple itself. For example, utilities trade at much lower multiples than tech companies because they generally have higher capital investment requirements and lower growth expectations. Subscription software providers trade at higher multiples than construction companies because their subscription-based revenues are more predictable, and their margins often increase significantly with scale.

Multiples have their place as broad estimates of value but lack the precision to reflect dynamics specific to the business and owner. Maximizing valuation derives from being able to pinpoint and articulate a company’s true value drivers.

Implications

Current economic conditions introduce significant uncertainty into valuation. Companies’ cash flows may be suffering due to reduced revenues, slower payments from customers or increased needs for investment. Near-term growth may be slow or non-existent. And, M&A demand may be anemic as potential acquirers focus on stabilizing or investing in their existing businesses. Most importantly, acquirers and investors may be hesitant to invest when it’s unclear what the near future will bring.

But, as they always do, markets will stabilize. And owners can take heart that the elements of fundamental value don’t change, even in challenging times. Businesses that are able to continue serving customers and demonstrate long-term growth prospects will see less reduction in value. Those that are able to identify new growth opportunities or ways to more efficiently generate profits will come out even stronger than they went in. Sustaining key value drivers and highlighting them for buyers will be more important than ever as markets return to normal and companies recover from the impacts of the COVID-19 pandemic.

For more insights from the series, The Path to Private Company Liquidity: A practical guide to M&A for business owners, click here.