The Value Tree: A Strategic Spin on the Popular Valuation Formula

Anyone who has worked in investment banking or private equity, or has ever bought or sold a business, is (or should be) well familiar with valuation multiples – one of the more simplistic, yet disarmingly useful, techniques for determining what a company is worth.

The simple formula of “Enterprise Value = EBITDA x Multiple” is a nifty black box that combines various factors – both quantitative and qualitative, objective and subjective, measurable and mysterious – to provide a quick answer that otherwise financial analysts derive from massive and complex financial models.

The Value Tree framework makes use of the popular valuation formula: Value = EBITDA x Multiple to create a universal recipe for identifying, prioritizing and connecting corporate initiatives into a cohesive strategic story.

The power of this methodology is in its simplicity and its universality.

The multiples-based valuation method simply postulates that a company’s worth is equal to the operating profit it generates times a subjective factor of how attractive investors believe these operating cash flows to be (compared to, say, another company that generates the same cash flows). One (EBITDA) is based on objective, measurable reality; the other (multiple) on subjective, ambiguous perception.

The power of this methodology is in its simplicity and its universality. It reflects how things generally work in life and nature. A blend of seemingly clashing, yet mutually reinforcing, dichotomies – science vs. art, rationality vs. emotions, right brain vs. left brain, evidence vs. judgment, facts vs. beliefs... The answer inevitably is: it’s a combination of these diametrical factors.

To apply The Value Tree framework, one just needs to work their way down from the top, translating broad objectives into narrower goals, and ultimately into specific actions, projects and initiatives. And once the lower-level activities have been identified, and their expected results and KPIs defined, it becomes possible to quantify their impact on shareholder value, and therefore assign them relative priority. Conversely, one can also start with existing initiatives, and identify where on the Value Tree do they belong and estimate how much shareholder value they would create.

For example, let’s consider a company with $100M in EBITDA, trading at a multiple of 5. It’s currently worth $500M. An initiative, say entering a new market, that delivers an incremental $20M in EBITDA is worth $100M in newly created shareholder value. Another initiative, say, a rebranding campaign that changes the image of the company from an ‘industry dinosaur’ to a ‘digital innovator’, would raise its valuation multiple to 8, thus creating shareholder value of $300M. Execute both successfully, and their joint impact is compounded to $460M, which includes $60M in synergy between the two initiatives.

Let's delve into each element of the framework to demonstrate how it can be used by strategy professionals to organize corporate initiatives into a cohesive portfolio and assign them priority based on their quantifiable potential to create meaningful shareholder value.

The EBITDA branch is the more ‘straightforward’ half of the framework. It deals in objective, observable numbers.

EBITDA

This is the more ‘straightforward’ half of the framework. It deals in objective, observable numbers. It captures initiatives that have immediate, measurable and direct impact on EBITDA. Any initiative that is immediately (or at least very quickly) accretive to the operating profit of the company belongs here.

Just like the multiple valuation method that it was inspired by, the Value Tree framework takes a static snapshot of EBITDA in the present moment, and any initiatives that are expected to deliver future EBITDA growth, but are not immediately additive, are reflected on the Multiple side.

There are two distinct value-creation philosophies that investors follow when they evaluate businesses strategically: either increase EBITDA by expanding the existing business (via M&A, new products, new clients, new geographies, etc.) or increase EBITDA by optimizing the existing business (via cost cutting, revenue yield management, pricing strategies, etc.)

To use an athletic analogy, Growth is like Talent and Yield is like Fitness. They are very different. You need both to be a champion. And one is not a substitute for the other.

Growth

Initiatives that increase operating profits by growing the revenue base of the business, while creating cost synergies, belong here. These include expanding its client base, product portfolio, market penetration, etc. Companies pursue this kind of EBITDA expansion in one of two ways:

Inorganic 

This is the realm of the corporate development function, including M&A, joint ventures and strategic alliances. The motivations for most inorganic investments generally fall in one of two buckets:

• Scale

These acquisitions add volume from an existing business to a company’s own revenue base by combining businesses that generate EBITDA from the same or similar products, but access complementary clients, verticals, and geographies. Since the underlying product and operational capabilities are highly complementary, that also unlocks further synergies by eliminating duplicative cost structures.

• Innovation

This type of M&A is about acquiring capabilities that the company does not currently have and deems economically infeasible to develop internally. This includes buying new product capabilities, technologies and intellectual property that are already generating positive EBITDA.

Organic

Alternatively, companies choose to cultivate growth organically, especially when they are capable and confident of their internal capabilities. Such initiatives fall in two broad buckets:

• Supply

This is where product research and development (R&D) initiatives reside. They entail studying customer needs and satisfaction, creating new products and services, features and variants, and rolling them out into the marketplace rapidly and successfully. This is also where many business development initiatives fall, especially those focused on new customer offerings via commercial and strategic partnerships and on the creation of marketplace ecosystems that unlock new client-facing capabilities and secure access to new product inventories. Finally, here I include initiatives that ‘productize’ assets and capabilities the company was not previously providing (think a museum launching a corporate events offering or a large retailer creating its own digital media network).

• Demand

This is the domain of new client acquisition, primarily driven by the sales function. It encompasses a broad set of initiatives that open up new geographies and industry verticals, attract and win new customers and contracts, and generally create greater distribution for the company’s existing products. Some of this expanded distribution comes in the form of channel partnerships with other industry players, driven jointly by business development and sales.

Yield

Here I capture initiatives that generate incremental EBITDA by optimizing and fine-tuning the existing business. This is the world of best practices, benchmarks, process and data standardization. Generally, it’s about helping the company become an EBITDA ‘elite athlete’ within its existing industry and product portfolio. I follow the basic formula “Profit = Revenue – Cost” to split this area in two buckets:

Revenue

This is where I categorize traditional sales productivity and performance marketing initiatives, including all promotional activity. It is also the realm of revenue optimization and yield management. It’s about squeezing a few extra drops of revenue ‘juice’ from the existing client base and product portfolio, but when done at scale, results in meaningful EBITDA enhancement. The travel and hospitality industries pioneered and perfected this discipline, and the same principles and techniques are now applied across industries. I use the formula “Revenue = Volume x Price” to break this space into two components:

• Volume

Volume optimization initiatives motivate customers to purchase more of the same or try new products. All promotions up and down the marketing funnel, including price discounts, product bundling, sampling, free trials, loyalty schemes, etc. reside here.

• Price

Price optimization is all about increasing the average unit price the company extracts from existing customers for its existing products. Sometimes it’s about repricing and price increases, but most of the time these initiatives are about upselling, converting to premium, and changing the product mix the customer buys. This is also where new ‘monetization’ efforts would fall. These are initiatives that introduce a price for products, services or features the company was heretofore providing for free (think charging for checked luggage or imposing account inactivity fees).

Cost

This is the area everyone, except private equity firms and restructuring consultants, love to hate. But cost management is a powerful tool for boosting EBITDA and creating shareholder value. There are many frameworks developed and applied by various consulting firms that specialize in cost optimization. For simplicity, I used the formula “Cost = Variable + Fixed” to divide this area into two parts:

• Variable

This is the world of procurement professionals, inventory optimization, demand management, waste reduction, commission structures, and a number of other disciplines specialized in reducing the cost per unit sold companies incur. Any initiative that tackles cost of goods sold, variable labor, cost of inventory or variable commissions belongs in this bucket.

• Fixed

Here I capture initiatives that tackle large cost buckets, such as office space and other real estate, overhead labor and benefits, production, infrastructure and office equipment, utilities, insurance, intellectual property development, etc. Increasingly, companies are switching to business structures and operating models that ‘variablize’ these traditionally fixed costs (think WeWork office space, fixed assets sale-leaseback transactions, outsourcing entire support functions, etc.)

Multiples are about intuition (a.k.a. gut), expectations, judgment – and of course, comparisons. 

Multiple

This side of the framework is more about art, intuition and judgment – and of course, comparisons with similar companies. It encompasses both somewhat quantitative and predictable factors, such as tax planning and capital structure, as well as highly subjective ones, such as perceived competitive advantages, economic moats, anticipated future growth, and quality of leadership. Collectively, these factors get ‘mashed up’ into a single number that levers up or down the value of the business operation. Generally, initiatives whose impact on operating profits is either hard to quantify or is realized over a longer-term horizon belong here.

I divide the Multiple factor into two principal categories: one that’s more subjective and unstructured, and one a bit more formulaic and quantifiable.

Appeal

As the name indicates, this is the most subjective category. The best way to think about it is in terms of the two principal (and generally, irrational) motivators of investor actions: greed and fear, which is how I divide this element of the framework:

Assets

This is a pretty broad bucket. It encompasses everything a company possesses that gets investors excited and eager to reach for their wallets. All proprietary, hard-to-replicate, scarce assets and resources, both physical and intellectual, that a company can leverage to beat out the competition, extract greater ‘economic rents’, and generate future growth belong here.

• Intangible

This is probably the single most impactful element in the entire framework. Investors’ perceptions of a company’s intangible assets and competitive advantages can sway the market multiple significantly. The reasons why some companies command stratospheric P/E ratios (e.g., 110x for Amazon or 31x for Google) are all baked into this bucket of intangible assets and capabilities that investors perceive these companies possess. Initiatives that add to this endowment of prized assets belong here. These include organic and inorganic investments in intellectual property (e.g., brand-building, patents, trademarks, proprietary R&D, creative content, and software code), human capital (e.g., culture-building, talent recruiting and development, and a high-quality C-suite and leadership bench), and proprietary contracts and relationships (e.g., exclusive licenses, activation and distribution rights, first-party consumer audiences, client lists and direct buyer relationships).

• Tangible

Traditional and physical assets that differentiate and enable the company to grow and outperform competitors belong here. Some examples are: real estate, equipment, and other property, as well as all varieties of financial assets. Initiatives that acquire, develop and enhance these assets (e.g., leasehold improvements, equipment upgrades, capital acquisitions, investments in production, logistics and distribution networks) are included in this category.

Risks

This is the inverse of the Assets category. It captures everything, either within the company or in its external environment, that would damage or undermine its chances of delivering the expected EBITDA and growth. Risks (and uncertainties) get investors spooked and cause them to discount the present value of the company. All initiatives that mitigate such risks belong here.

• Internal

Risks that emanate from within the company and how it operates reside here. These include compliance risks, operational risks, reputational risks, key-person risks, credit risks, liquidity risks, etc. Any initiatives that either prevent, mitigate or help recover from the impact of these risks (e.g., process controls, leadership succession plans, process and supply redundancies) fall within this area.

• External

Risks that originate outside of the company, presented by external players and environmental factors, belong here. For example, competitive threats, regulatory burdens, market or political unrest and uncertainty, supply-chain disruptions, legal actions taken by competitors, customers or suppliers, etc. Initiatives that tackle these external risks (e.g., business continuity plans, competitive intelligence, market analyses, strategic and marketing plans) are categorized here.

Structure

Since EBITDA is calculated before interest and tax, it doesn’t reflect any benefits (or burdens) created by the company’s incorporation, capitalization, legal or tax structure. These factors are all baked into the multiple. Different corporate and financial structures can have both quantitative, measurable (tax-related) effects on shareholder value, as well as qualitative, perceptional effects. I organize these structures into two buckets, one related to how the business is organized, and governed, and the other, to how it is funded:

Corporate

This area includes everything to do with how the company is incorporated, owned, organized, and governed.

• Ownership

Where and how a company is incorporated and what ownership structure it has (e.g., Delaware vs. Cayman Islands, public vs. private, standalone business vs. holding vs. subsidiary) are factors that have an impact on shareholder value. Who the owners are (e.g., founders vs. a family vs. financial sponsors vs. strategic investor) can also impact its multiple, and thus, its worth. Initiatives that aim to create shareholder value by manipulating business structure, ownership composition and corporate organization (e.g., spinoffs, takeovers, reverse mergers, reincorporations) are captured in this area.

• Governance

In addition to how it is organized and owned, how a company is overseen and governed is another qualitative factor that impacts its multiple and valuation. This includes how formal and transparent its board of directors (BOD) and management structures and processes are and whether individual players (e.g., charismatic founders, long-serving CEOs, family members of family-owned businesses) have undue or outsized influence and control. Initiatives that strengthen these elements (e.g., independent director appointments, BOD process redesigns) belong here.

Capital

This is the domain of corporate financiers, investment bankers and private equity professionals. The mix of equity and debt financing, the choice of instruments, and the total cost of capital are meaningful levers of shareholder value.

• Equity

The level of equity financing, the mix of instruments (e.g., shares, options, warrants), the levels of priority, restrictions, and voting rights are all elements of the capital structure that impact shareholder value. Initiatives that affect the company’s equity cap table (e.g., equity raises, share repurchases, stock options grants) belong in this area.

• Debt

There are many reasons why corporate finance professionals and private equity investors like debt – it helps multiply (‘lever up’) the return on equity investment, it provides a tax shield since interest is tax deductible, and it keeps the management team disciplined and focused on operating profits, which are used to make ongoing debt service payments. Too much debt, however, strains the company’s cash flows and can force even good businesses into bankruptcy. Which is why high leverage ratios can create negative perceptions among creditors, vendors and clients, and erode shareholder value. Initiatives that relate to the company’s debt levels and structure (e.g., refinancing, recapitalizations, leveraged buyouts, debt restructuring, bankruptcies) fall within this bucket.

Using The Value Tree framework, CSOs can unify, prioritize and measure the entire portfolio of strategic initiatives using a single currency: shareholder value.

There are two principal benefits of applying the Value Tree technique: First, it allows strategy professionals to take an existing corporate portfolio of initiatives that exist in disparate corners of the organization and unify them under one centralized and cohesive strategic narrative and governance process. Second, it applies a ‘single currency’ – shareholder value – to assess the ‘size of the prize’, and therefore the priority, of each initiative, which can be calculated fairly objectively either by measuring the immediate accretive EBITDA of the initiative or by estimating (through the use of market comps) its impact of the valuation multiple.

The Value Tree framework is a useful universal tool for CSOs and their teams. But it is not intended to replace the strategic plan or vision or narrative that the leadership team may have already developed – it should be used alongside these other strategy tools to help organize, prioritize and create consistent process and standards to manage the corporate portfolio of strategic initiatives.