The GRAPES of Value Revisited

Growth

Growth, along with risk, are the two biggest factors in determining the value of a business.? In short, higher growth companies are worth more than those with flat growth or negative growth. It is also important to define how we are measuring growth. Are we talking about growth in revenues, EBITDA, Seller’s Discretionary Earnings, or net income? A business might have growing revenues but its cash flows may be trending in the opposite direction.

The other relevant factor is how consistent has the growth been? Many companies suffered during the pandemic but then bounced back to previous levels. Cyclical companies may experience growth during certain portions of the economic cycle but this does not mean growth has been sustainable over a long period of time. In contrast, a company with consistent year-over-year growth for more a decade or more is telling a strong story to a prospective investor.

The last thing, which is critical to assess, is whether future growth is expected to continue. We’ll talk about expectations more later, but if significant changes have occurred in the industry which may adversely impact the company's future ability to generate profits, the value of that company might be discounted to reflect that uncertainty.

Risk

The second great determinant of value is risk. The thing about risk is that it is quite personal, and one person’s perception of risk is different from that of another person. This is because people have different aversions to risk and they may weight certain factors differently. For example, low margins might be a lower risk to someone confident they can scale up a business, while another person may view that in a strongly negative fashion, perhaps even enough to walk away from a deal.

If you are a business owner considering selling the next few years, de-risking the business is one of the most valuable projects you can undertake. This process can be analyzed at the planning stage whereby a game plan can be put together. De-risking a business means making it easier to predict its future results. This can be done through mitigating potential adverse results to the business, and through making the future of the business clear to understand (i.e. business plan, forecast, monitoring of results). Buyers want to be able to have an idea of what they are purchasing and when this is unclear, they will either walk away or offer a low bid to the seller.

Alternative Investments

Buying a business is really just a type of investment. Some people invest in GICs, some invest in public equities or bonds, while others invest in private businesses. There are even riskier investments such as venture capital and angel investing. All investments require a return that is commensurate with the risk the investor is assuming. In the case of a business, the sales price will determine a buyer’s return on investment (ROI). If they overpay for the business, their ROI will be lower, while if they buy a healthy business at a relatively low price, their ROI will be higher.

A prospective buyer of a business may be look at multiple businesses in their search. As part of their analysis, they will make an assessment of the relative attractiveness of each investment. Thus, if they run across a business they feel is over-valued, in their assessment, they will consider the alternatives before them. If there are other business that present better opportunities for return, that prospective buyer may eliminate the over-valued business from their search. That buyer may also take a look at a group of businesses and conclude that they would be better to investing their money in the stock market rather than buy a business. This is the principle of alternative investments in action. Every investor will compare opportunities before them and ultimately choose the one they believe presents the best opportunities relative to risk.

Present Value

Value is always expressed in terms of present value. We live in the present but the benefits from owning a business are to be generated in the future. However, $1 earned tomorrow is worth less than $1 earned today due to the reality of inflation. Thus, when we express the value of a business, it represents the present value of the future benefits (usually measured in cash flows) to be obtained from operating that venture. Value is adjusted for the time value of money along with the risk of earning those benefits.

From a seller’s perspective, it’s important to note that growth in the distant future is worth less than growth in the present or near future. Thus, a business whereby cash flows are expected to grow significantly in the next year may be valued more than a business where growth isn’t expected until five years in the future.

Expectations

Following up from the point above, value is an expression of future expectations. A very profitable business that is expected to decline due to changes in the industry may not be worth much to an astute investor. Similarly, a business that has struggled but secured a few massive long-term contracts might be valued high.

You’ve likely heard the expression “past performance doesn’t guarantee future performance”. This is true for businesses, as well. While analyzing past profitability is common when valuing a company, the question every prospective buyer needs to ask themselves is “how will this business perform after I buy it?” This is why issues such as customer concentration and lack of owner independence are so critical because it ties back into future expectations. If the business has a strong risk of tanking after the transaction close, the value of that business will be seriously impaired, if any buyer can be found.

Sanity

Valuation is based on prudent business principles in theory. In reality, selling (or buying) a business can get emotional. Also, potential buyers might weigh risk factors differently. Each buyer may have different perceptions of how they can make this company grow after they acquire it. This means that if you gave the exact same information to ten potential buyers, you’d likely get ten different valuations. This is why we often express fair market value in a range rather than at a singular point.

What Can You Do?

What does all this mean to you as a business owner? From a planning perspective, we can use the GRAPES of Value to help us understand value creation so we can maximize the value of our business when it is ready to sell through putting together a written growth plan.

One key takeaway here is that growth and risk are the real drivers of value while the others aspects of value all tie back to those two factors. If one focuses on growing the business, for example, they will also make the business more attractive compared to alternative investments, and will increase expectations. Similarly, if one focuses on de-risking the business, this appeals to the sanity and expectations aspect of value.

If you have not done so already, January is a great time to look ahead and start building your growth plan. This is an important investment of your time and resources that can pay dividends down the road with a more valuable and sellable business.