Maximizing Value Throughout the Business Life Cycle

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Maximizing Value Throughout the Business Life Cycle

Most business owners think about valuing their business and how to get the best deal when it’s time to sell.   While some owners consider their company’s value from inception, too frequently owners give no consideration to value creation until much later, often when it’s too late to affect value.  In fact, value is created from the design of the business plan all the way through the close of the final business sale.

This paper explores value creation and how valuation-centric analysis throughout the business life cycle not only maximizes value but compounds the effects of accelerating value. 

The graph below depicts the business life cycle and when cash flows are typically achieved. 

Business Life Cycle

Value is ultimately derived from the timing, amount, and risk of a business’s cash flows.  If an owner is able to shift the above graph, the rate of value creation is enhanced, improving and compounding the owners’ wealth both during and after the business is ultimately sold.

Cash Flow

LAUNCH

I have seen untold business plans; some well thought out, some with massive holes, but few with good financial planning and modeling.  At the launch phase, valuations necessarily incorporate detailed projections of unit sales, pricing, cost, and infrastructure components.  This analysis helps answer many questions fundamental to a successful launch.  It also helps the owners understand the level of capital required, its likely sources, costs and possible dilution, and the timing and number of tranches that may be necessary.  A competent valuation will help attract capital, and at the lowest cost, in addition to “cleaning up” the plan and focusing Management on the most value-maximizing strategies.

Mistakes at this stage are costly, as restarting or re-engineering leaves investors and lenders with little confidence and ability to fund further.  The track record of the owner is negatively affected and often difficult to recover from.

Additionally, getting the capital structure right is critical at the start; there are no second chances here.  Options, warrants, preferred equity, and debt with privileges and features all have values and associated costs.  There is no way to understand the economic ramifications of these decisions without sophisticated modeling as component parts of the financial forecasts and expected ultimate sale.

GROWTH

Execution is critical during the growth phase as this is when a business model is perfected affecting many future years of financial performance.  The value drivers of the business start to come to light and modeling the effects of those drivers helps optimize strategies and the allocation of finite resources.  Scenario and sensitivity analysis aids in understanding the cash flow and value impact of dollar or percentage changes in investment and performance.  Anything short of detailed and creative modeling is guess work.  While intuition has its place, financial modeling offers a more consistent framework on which to build and understand value.

Strategic and growth planning is a dynamic process.  Marketing econometrics that lead to better and optimal strategies at this stage often have the highest return.  Additional capital raises may be required or desired.  Management planning, incentives and compensation analysis are often helpful during this phase.  Understanding the market price of these decisions is important to maximizing value.

Growth can be achieved many ways, but there are only two basic paths:  organic and acquisitive.  Both need to be examined as the “build versus buy” decision is almost always in play.  While investing and building operations is always a viable option, so is acquiring other companies that could accelerate growth or play a strategic role.  Valuation analysis is multifaceted here.  Value creation needs to be assessed based on the tradeoffs of the build versus buy decision.  By growing organically, an owner might take less risk, and better control growth and operations.  By acquiring, an owner hastens the growth of the company, creating business synergies and often bolstering investor returns.  The acquisition method, though, is somewhat riskier as each acquisition must have a strategic fit and be acquired at the right price.  Sometimes a single poor-acquisition can leave a young firm struggling not only to grow, but to survive.

SHAKE-OUT

This phase is often characterized by the entrance of new competitors, and while sales may be increasing, margins are sometimes squeezed.  As investments decline, cash flow may improve, and the owners may enjoy enhanced distributions.

The goals of valuation analysis in this phase are to tweak the business model, help in the planning process, and provide ongoing visibility via better decision-making tools.  This can be accomplished through updated valuations (typically yearly), capital structure optimization, and business optimization that often involves detailed data analysis of operations, pricing elasticity studies, or other metrics that can improve cash flow.

Additionally, financial planning and analysis (FP&A) tools and support are very useful in helping Management budget, plan, and make informed daily decisions.  The visibility gained by using this “dashboard” model has been quite instrumental in lowering risk and managing cash flow for many companies.

MATURITY

This life cycle phase may be the most relaxing but the least rewarding.  Too many competitors, too little growth, and declining profits often accompany this phase.  Cash flow is often flat as major investments are in the rear-view mirror.  Not a bad place to be unless you’re the type who needs to reinvent yourself, which sometimes happens.  Even so, valuation modeling can help extend the life cycle through better planning.

There may be transactions during this period with managers, outsiders (maybe taking a few chips off the table) or family, such as with children working in the business.  Valuations are needed for all these circumstances, and the IRS is keenly aware of “gifts” to children based on undervalued stock.

The maturity phase is also a good time for succession planning; predominately to understand the alternatives and the wealth ramifications of different strategies.  These strategies include leveraged recapitalizations, private equity investments, management buy-outs, and ESOPs.  No matter which strategy is selected, an analysis of exit-timing is instrumental to generating the greatest sale price for the business.

EXIT

Few owners want to think about the exit because it triggers negative thoughts, not the least of which is one’s own mortality.  That said, leaving a legacy to its stakeholders is usually important.  But self-interest also dictates that owners receive the maximum benefits for their decades of hard work.  Performing analysis of value and understanding strategic value to acquirors may be the most important valuation undertaking over the life cycle.  Often, it’s the last chance to get it right.

Understanding strategic value is best accomplished through detailed valuation and synergy analysis, presentation decks, and effective financial and legal representation throughout the sale process.  Adjunct analysis can be informative as it includes an understanding of the after- tax wealth differences between various deal structures.  Hopefully, some of the measures during the earlier phases have been completed making the exit more effective and rewarding.  The sooner owners understand the drivers of value and how to promote those assets most efficiently, the greater the value seen at exit.

Hopefully, this paper has highlighted that valuation is far more than appraisal.  It’s about value creation and its many forms.  Utilizing these tools over the business life cycle can accelerate and improve the business, while creating additional wealth to its owners and stakeholders.

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

 

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Is it Time to Change the Name of the Most Valuable Player Award?

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Is it Time to Change the Name of the Most Valuable Player Award?

Is the Most Valuable Player really that?  Or, is he the Best Player?  Or, is that the same thing? 

The answer might not be as obvious as you think.

Consider the NFL as one of the better proxies for analysis, in part because of the hard salary cap.  The MVP is usually awarded to the player that does well personally (i.e. has some of the best stats like quarterback (QB) rating, total touchdown passes and touchdown/interception ratio, total rushing yards, etc.) and helps carry their team to wins and playoff berths.  You would think that those in consideration for the award are some of the highest paid players in the NFL.  Since they are often quarterbacks, let’s take a closer look.

It turns out of the 32 starting QBs, 12 make single digit annual salaries (yes, in the single digit millions) and 20 make double digit salaries (the vast majority over $20 million).  One would expect the MVP is most likely to come from the pool of 20 since there must logically be a correlation of salary to performance, and in turn team success.

In fact, of the 12 teams that made the playoffs this year, 6 QBs made single digit salaries and 6 made double digit salaries.  So, while 30% of the highly paid QBs made the playoffs, 50% of the lower paid guys got in.  The average salary of QBs who made the playoffs was $12.7 million, while the average salary for those that did not was $18.3 million.1

Further analysis shows that there is a negative correlation between salary and playoff seeding.  That is, some of the highest seeded teams (normally with the most wins) are the Chiefs (Mahomes), Texans (Watson), Rams (Goff), Bears (Trubisky).  In fact, the top 6 highest paid QBs are not in the playoffs at all (Aaron Rodgers, Matt Ryan, Kirk Cousins, Jimmy Garoppolo, Matthew Stafford, Derek Carr).

What’s the explanation?  In the era of the salary cap, being in the first four-year contract period (Prescott, Mahomes, Watson, Goff, Trubisky, Jackson), or taking a discount (Brees, Brady, Rivers, Wilson, Luck make $20 to 25 million) saves cap room to pay other good players, thus making the team better and, arguably, the QB more valuable.

When looking at salary relative to production, the difference is stark.  This year, Rodgers earned $1.3 million per passing touchdown thrown, while Prescott earned just $30 thousand.  In terms of salary per win, Rodgers was paid 82 times that of Prescott.

The point is value has to be considered in the context of cost (i.e. salary), as does the value of anything!  The more the cost, the less valuable, all other things equal.  Therefore, while good QBs might make more, they might be less valuable, or at least no more valuable than cheaper QBs. 

It turns out that maybe the most valuable quarterback is not the “best” (all other things equal) and/or highly paid so long as their lower salary helps create better play and wins, which apparently it does.  Sorry, Aaron Rodgers.

Nfl Mvp

1. Lamar Jackson and Nick Foles were utilized as the QB for their respective playoff teams.

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

 

If you liked this blog you may enjoy reading some of our other blogs here.

The Relationship Between S&P 500 Returns, Earnings Growth, P/E Expansion, and Interest Rates

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The Relationship Between S&P 500 Returns, Earnings Growth, P/E Expansion, and Interest Rates

The S&P 500 increased from 2,789.80 on January 1, 2018 to 2,924.59 on October 1, 2018, a year-to-date return of 4.83%. As shown in the graph below, this return was fueled by a solid increase in earnings of 9.20% but was partially offset by a contraction of 4.37% in the P/E ratio.

 The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

While S&P 500 returns result from both P/E ratio expansion and increases in earnings, these factors have historically been negatively correlated.  This means that the offsetting effect that we see above holds for monthly data over a longer period of time.  In fact, the relationship for the period January 1970 through October 2018 as determined by linear regression is:

Monthly Increase in Earnings = 0.58% – 27.42% × (Monthly P/E Ratio Expansion)

Based on this regression, a 2% decrease in the P/E Ratio will likely be accompanied by a 1.1% increase in earnings, yielding a negative 0.9% S&P 500 return.

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

The graph below illustrates the historical relationship of monthly increases in earnings and monthly P/E Ratio expansion.

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

While we see an offsetting effect in monthly P/E ratio expansion and monthly increases in earnings, both factors have contributed to cumulative S&P 500 returns since January 1970.  The index has increased 3,138.4% over this period, while earnings have expanded by 2,037.2% and the P/E ratio has increased by 51.5%.1  If we allocate the multiplicative component of the S&P 500 to earnings expansion and P/E ratio expansion, we find that 97.5% of the cumulative return in the S&P 500 since January 1970 has come from expansion in earnings, while 2.5% of the cumulative return is attributable to the growth in the P/E ratio.  The chart below depicts the cumulative S&P 500 return.

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

While S&P returns over long periods of time are attributable to earnings expansion, the variation in monthly returns is primarily explained by changes in the P/E ratio (approx. 62%).  The chart below illustrates the relationship between monthly S&P 500 returns and the monthly percent change in the P/E ratio.

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

Historical Distribution of the P/E Ratio

During the period January 1970 to October 2018, the S&P 500 P/E ratio averaged 19.5x. However, for the majority of the period, the P/E ratio was less than the 19.5x average. The P/E ratios had remained above the average for the last 48 months.

During the period January 1987 to October 2018, the P/E ratio averaged 23.5x and the median P/E ratio was 20.5x. In the last 15 years, the average P/E ratio has moved further upwards to 24.5x.

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

The S&P 500 P/E ratio as of October 1, 2018 was 23.9x, which is 22.6% higher than the historical average of 19.5x. At the same time, it was trading below the last 15 years average of 24.5x.

Interest Rates Compared to P/E Ratio

From our prior paper2 discussing S&P 500 returns, we know that the P/E ratio is theoretically a function of the long-term growth rate in earnings and the required rate of return.  From January 1970 to October 2018, the Federal Funds Rate averaged 5.23%. At the same time, the S&P P/E ratio averaged 19.5x. From 1973 until the end of 1991, interest rates were almost always above the historical average. Most notably, in 1980 and 1981, the Federal Funds Rate rose to 20.00% on four occasions over the two-year period, the highest interest rate in United States history. However, the Federal Funds Rate has averaged 3.50% since 1986 and for the last 25 years, interest rates have remained below the historical average, plummeting to 0.15% in 2009. For the following seven years, the interest rate remained low and only began to increase in December of 2015 when the Federal Reserve determined that economic growth had stabilized. Due to low interest rates since the great recession, the Federal Funds Rate has averaged 1.34% in the last 15 years. It can be seen that the average interest rates have been falling for a long time and had only recently picked up. With some recent increases, as of October 2018, the Federal Funds Rate was 2.20%.

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

It can be observed that the relationship between the P/E ratio and Federal Funds Rate changed during this long period. It appears that the change happened somewhere near 1990. Before August 1987, the P/E ratio and Federal Funds Rate displayed the following logarithmic relationship:

P/E ratio = -6.173 ln (Fed Fund Rate) – 3.6381

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

Alan Greenspan took over as Fed Chairman in August 1987. He supported an easy money policy and started reducing interest rates soon after. With a change in the Fed’s policy, the relationship between the P/E ratio and interest rates changed to a very weak linear relationship.

P/E ratio = 27.292 – 94.08 (Fed Funds Rate)

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

The outliers circled above occurred during recessionary periods. After removing the outliers, the relationship between the P/E Ratio and Federal Funds Rate remains weak, as shown in the chart below.

The Relationship Between S&Amp;P 500 Returns, Earnings Growth, P/E Expansion, And Interest Rates

Conclusion

Analysts estimate an 80.7% chance of at least one more increase in the Federal Funds Rate3 before the end of the year.  While the prior relationship and financial theory would predict that increasing the Federal Funds Rate would lead to a decline in the P/E ratio through an increase in the required rate of return, our analysis shows that this relationship no longer holds.  In future papers, we will investigate the determinants of the S&P 500 required rate of return by examining the implied equity cost of capital.

1. 3,138.4% = (1 + 2,037.2%) x (1 + 51.5%) – 1

2. https://www.valuescopeinc.com/resources/white-papers/the-sp-500-pe-ratio-a-historical-perspective/

3. CME Group, FedWatch Tool, November 8, 2018

The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

 

If you liked this blog you may enjoy reading some of our other blogs here.