The goal of most business owners is to increase the value of their company. However, in many cases this discussion does not arise until the business owner decides it’s time to sell the company. In most cases, this is too late in the game to have the discussion. Business owners that focus on building shareholder value throughout the life of their companies will create healthier more profitable companies than those that do not. In many cases, these healthier companies will in turn, lead to stronger economies, higher living standards and more career opportunities for individuals.
In the real market, you create value by earning a return on your invested capital greater than the opportunity cost of capital. The more you invest at returns above the cost of capital the more value you create (i.e. growth creates more value as long as the return on capital exceeds the cost of capital). Business owners should select strategies that maximize the present value of expected future cash flow or economic profit.
There are two key drivers of company value: the rate at which the company is growing its revenues, profits and capital base and the return on invested capital (relative to the cost of capital). These value drivers make common sense. A company that earns a higher profit for every dollar invested in the business will be worth more than a similar company that earns less profit for every dollar of invested capital. Similarly, a faster growing company will be worth more than a slower growing company if the both are earning the same return on invested capital.
If we look at the key drivers of company value more closely, here is what we find:
Profit Margin: This reflects the portion of revenue that remains as profit after paying operating costs, such as manufacturing costs, R&D, sales, general and administrative etc.
Asset Productivity: This term refers to the amount of Revenue that you generate from each dollar invested into Operating Assets (i.e. Revenue/Operating Assets). These assets may include such things as property plant and equipment. The more productivity we get out of existing assets or the same productivity we get from fewer assets, the higher the return on invested capital. This higher productivity typically leads to higher revenue, profits and company value.
Growth: A growing company and a stream of cash are worth more to investors than if it were constant or declining. Profit growth is what’s important; a growing company has the opportunity to generate more profits faster and as a result receives a higher value.
There are two fundamental ways to improve profits: increase revenues and or reduce costs. Increasing revenue can be done by:
Strengthen pricing: Success here may mean charging more, holding prices flat, or even slowing price declines. When increasing prices with a repeat customer, you will often need a compelling business reason, such as fuel cost pass-through, severe supply shortages, or a breakthrough new product feature. Analysis on competitor’s prices and your product advantages/disadvantages can give you a solid footing in price negotiations. If you have a large number of customers (like a retail store), you can experiment with different prices to see the impact on sales volume and then set prices to optimize profits. Some customers are willing to pay more than others, and you should look for ways to set different prices for these different customers.
Optimize Product/Customer Mix: Some products are more profitable than others. Likewise, some customers are more profitable than others. When your operations are constrained (e.g. by manufacturing capacity or personnel), you may want to cut low-profit products and customers to make room for high-profit ones. Be careful here not to shoot your golden goose by losing a key customer that you will need later on.
To reduce your product/service cost, set specific goals and incentivize your employees to achieve them. You may set a goal to reduce manufacturing spending by $1M and then pay out $100K in incentive if the goal is achieved. Set goals and incentives each period, and make it a part of your company culture and a point of pride. To help seed cost reduction efforts, identify your largest cost drivers (like raw materials, rent, utilities, and labor), break up the spending categories, and assign a team to each area.
R&D spending is another important focus area for improving profit margin and in turn company value. There are two things to consider when optimizing your R&D investment – setting the right budget and managing R&D productivity. To set the right R&D budget, start out by looking at how much other companies in your industry spend as a percentage of revenue. If your industry spends 10% of revenue on R&D, then this may be a reasonable starting point for your spending. If you have a high growth business relative to your industry, your spending may need to be a larger percentage of revenue. R&D productivity should reflect the quality of the R&D projects that are funded (i.e. are you funding worthwhile projects), speed (i.e. are you getting new products to market quickly), and efficiency (i.e. was the cost reasonable).
Optimizing SG&A spending is an important part of improving profit margin and growth. It is about setting the right spending budget and managing and rewarding productivity. You can again get started by looking at how much other companies in your industry spend as a percentage of revenue and then back into your implied spending level. Define your processes; identify value add steps; and eliminate all other steps. This approach often yields 30% cost improvements. Look to optimize sales, determine what a sale is worth to the company; consider the incremental revenue; the longevity of the revenue stream; and the cost to produce, deliver, and support the product volume. Ensure that sales compensation is heavily commissions based. This helps align incentives, but it also helps ensure that you are not investing more in sales than what you are getting in return.
Look separately at assets that are directly involved in generating revenue (like factories or delivery trucks) and those that are not (like office buildings). For revenue generating assets, look for opportunities to increase output. You may be able to stagger employee break time to keep equipment running; identify your bottleneck assets and improve their availability; or start running a facility 24 hrs a day. There are probably hundreds of ways to improve here, so think of this as continuous improvement rather than a one-time effort.
If you have assets that are not being effectively utilized 90% of the time, you may want to consider selling them.
For assets that don’t directly drive revenue, look for ways to eliminate waste. For example, what would it take to consolidate from three buildings to two? Does every employee need their own desk, or can frequent travelers share a few community desks? What if employees worked from home once per week? Can you use cubicles instead of offices? What about outsourcing some services to save cost and reduce assets?
Growth is a powerful lever for improving company value. Simply put, a growing stream of cash is worth more than if it were constant or declining. Driving growth requires time, motivation, and resources. The best way to manage for business growth is to assign an individual or team to focus on it, free up necessary resources, set goals and incentives, and hold the team accountable. Good ideas will never materialize without proper growth management in place. Once your highly motivated and skilled team is ready to embark on their mission, looking at your products and customers is a good place to start.
Sell more of your current products to your current customers
Sell your current products to new customers who are similar to your current customers.
Sell adjacent products that leverage your core strengths
Partner with a complementary business in a way that is mutually beneficial. For example, each company may introduce the other to their customers in order to grow revenue for both companies.
Advertise through the right channels. Where and how are your target customers being educated on products that you sell, and how can you advertise there?
Some businesses suite themselves well to a sales-force, either internal or contracted. The gauge is whether a sale brings in enough profit to afford the sales commission. If your business model can afford to send sales reps out after new customers, this can be a powerful sales approach.
If your product or service could enhance the offering of other companies, you should consider licensing your product.
The goal of most business owners is to increase the value of their company. Increasing focus on the rate at which the company is growing its revenues, profits and capital base and the return on invested capital is critical to driving business value. Business owners that focus on building shareholder value throughout the life of their companies will create healthier more profitable companies than those that do not. In many cases these healthier companies will in turn lead to stronger economies, higher living standards and more career opportunities for individuals.
Please let us know if you have questions regarding business value creation or any other financial, accounting or tax planning issues. We can be reached at (480) 980-3977.