HOW TO PICK A GREAT COMPANY

Could you pick a company with the best future prospects if you had a range of options to choose from? While the methodology for evaluating small and mid-market companies (up to $100 million in revenue) may vary slightly from that for large corporations, the underlying principles remain consistent. When assessing a company as a potential acquisition, additional factors like synergies come into play. Merging companies can increase market strength, reduce costs, or complement product offerings, often boosting value. However, this discussion will focus on identifying individual companies with strong long-term potential rather than analyzing them as acquisition targets.

What Defines a Winning Company?

The definition of a winning company depends on whether you're an investor, an acquirer, or an employee. Common characteristics include:

• High return on equity
• Sustainable and consistent growth in revenue and earnings
• Increasing market value
• Potential market leadership
• Consistent alignment of products or services with customer needs
• The ability to adapt and stay ahead in the market

Valuation Approaches

When analyzing a company, conducting a valuation can provide a clearer picture of its potential. There are three primary valuation methods:

1. Income Approach – Often involves discounted cash flow (DCF) analysis, factoring in expected income and risk-adjusted returns.
2. Market Approach – Compares revenue or EBITDA multiples of similar businesses, adjusting for risks or unique business strengths.
3. Asset Approach – Focuses on the company’s assets and liabilities, considering the cost to build a similar business that could offer the same economic value.

Evaluating Key Factors

There are both quantitative and qualitative aspects to consider when assessing a company. The relative importance of these factors depends on your understanding of the industry and its critical success factors. Even though smaller companies require a different evaluation method compared to larger corporations, the basic principles remain the same.

Early in my career, I participated in a strategic planning exercise with 30 other professionals. We were tasked with analyzing five large corporations (labeled A through E) using both quantitative and qualitative data. Our goal was to predict which would be the best and worst performers over the next five years. Out of 30 participants, I was the only one to correctly identify the top and bottom performers and present the rationale behind my choices. This exercise taught me the importance of weighting relevant information and distinguishing between critical and less significant data. With a mix of business acumen and analytical skills, you can often predict which companies will succeed and which will falter.

Six Key Areas to Evaluate

1. Market What is the market size? Is the market growing, mature, or declining? How are technology and social trends influencing the market?
2. Competitive Landscape Is the market fragmented, or dominated by a few companies? What are the strengths and weaknesses of key competitors?
3. Company’s Market Position What are the company’s strengths and weaknesses? Is it a market leader? How does its market share compare to competitors? What are its competitive advantages?
4. Operations Are processes efficient and effective? Are there issues with product production or service development?
5. Strategy Is the growth strategy based on acquisitions or organic growth? Are the marketing and operational strategies working?
6. Management In small and mid-sized companies, management effectiveness is often easier to evaluate. How does management respond to changes in the market or economy, such as declining revenues? Is there a balance between short-term rewards and long-term incentives? Does the corporate culture promote growth and maximize value? Are customer needs addressed effectively?

The Bigger Picture

When evaluating a company, it’s essential to look beyond historical growth rates. Consider how well the company adapts its products and services to changing customer trends, market conditions, and technological advances. Agility is crucial – the ability to pivot when necessary can make or break a company's future success. Additionally, understanding the external market and business environment is key to forecasting long-term viability.

By combining business experience with strong analytical skills, you’ll be better equipped to spot the companies with the greatest potential for long-term success.