Things are not always as they appear
April 19, 2013
A company structure can be an attractive size and shape, with a seemingly strong foundation--but still be a house of cards. Therefore, it’s important to test the robustness of a company’s structure to determine whether it is what it appears to be.
In the prior three columns relating to company valuation, I described the parameters that set the baseline valuation, often measured as a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization). These are, again, company size and the financials, including the margins and earnings. Finally, last month I went over the key market determinants that put a foundation under these parameters. This foundation provides a way to put a first-order risk factor on projections of probable future company size, margins, and earnings. And, of course, it’s the future that’s really important.
So we’re pretty much done, right? What more do we need? The fact that I’m still writing about valuation obviously means that we’re not done. So yes, there’s more—sometimes much, much more.
A million years ago I worked for a major corporation as a rookie general manager reporting directly to the CEO. This man was the smartest human being I have ever met. He was brilliant at cutting through the fog and getting right to the heart of virtually any challenge. He also was a master at company valuation who introduced me to the concept of valuation as a tool for improvement. I remember him taking me and a couple of other general managers to lunch one day and talking about how companies and product lines can be valued. We were relieved to be discussing such a benign topic. As usual, that relief was very short-lived.
What he said stuck with me, and experience has shown me that what he said is true. He said that a company can have a great outward appearance—its size and numbers may look great, it may seem like it has a solid foundation, it may do business in a market with a good environment and good characteristics, and it may have had great past performance in that market—but that company still may be a total dog.
My enlightened response to that claim was something like, “Huh?”
He said that a company structure can be an attractive size and shape, with a seemingly strong foundation—but still be a house of cards. It can look good but fail with even the slightest perturbation to its uneasy equilibrium. Therefore, it’s important to test the robustness of a company’s structure to determine whether it is what it appears to be. We are now at the guts of valuation and at the roots of improvement.
So what are the parameters—or as my CEO used to say, the “glue”—that provide strength to the structure? Many are industry-specific, and only a relative few are of concern here because they transcend size and markets served. But these few are especially relevant to fabricators and specialty custom manufacturers.
Believe it or not, most can’t answer this fundamental question. Even if they give a semicoherent answer, it often revolves around soft, generalized terms such as quality, precision, or service. Those are great attributes, for sure. But compared to what? Further, who told you that? Was it your customers or the pablum that we all seem to put on our websites and promotional literature?
Unless you know exactly why your customers choose your company, you cannot possibly improve in a focused, economical manner. It also means that your structure is a lot more wobbly than it should be, and your real valuation is probably lower than you want it to be. Why? It’s because not knowing why customers buy from you makes future performance much riskier.
So how do you find out why customers buy from you? Ask them—and ask them often—at many levels and in many forms. Listen to the voice of the customer. Be aware, however, that it is not simple. The answers must come without bias or manipulation. Those companies that really are serious about this have voice-of-the-customer inquiries done independently. Prospective buyers for your company are certainly independent, and if they’re buying your company, they will surely conduct voice-of-the-customer inquiries during due diligence.
Many smart people examine the win/bid ratio—that is, the number of jobs won versus the number bid. While far from perfect, it does indicate marketing (that is, value proposition) performance in the real market. A low ratio, especially with a high bid number in the denominator, indicates that a company is just tossing out bids on anything and hoping some stick. This means that the value propositions are weakly defined or simply unknown. A high ratio indicates the opposite.
Employee talent is a major part of the glue that provides strength to the company. Many, if not most, buyers put this broad category on a near-equal footing with past financial performance. Issues such as training, turnover, compensation (including means of compensation), and how authority is distributed are very important. So is access to talent.
Imagine you’re a buyer examining two fabricators with essentially identical major parameters: same size, market characteristics, and performance and similar financials. Company X is owned and managed by an extremely hard-working and brilliant person who makes every decision and trades the “inconvenience” of high turnover at every level with the assurance of low labor costs. This person micromanages every initiative and somehow makes the place work.
Company Y is managed by another hard-working individual who does the opposite. He sees high turnover as a serious and costly problem, tends to delegate authority, but backs it up with training and coaching. He often accepts “B” results from others as a learning experience, even when he could have micromanaged (that is, commanded) it to an “A” result. Through it all, he too somehow makes the place work. Which one would you put your money on with respect to future performance?
Yeah, me too.
Talent and depth in every critical skill are valued very favorably. The opposite has a serious negative effect on value. In fact, this single issue has broken many otherwise done deals.
So if a company’s value hinges on the talent and depth of critical skills, what are those skills? To a large extent, they are indicated by the company’s value propositions and the voice of the customer. That’s why I tend to harp on value propositions. It’s that important, and it’s also important in the following glue parameter: operations.
Operations entail a collection of all the tasks required to fulfill your value propositions to customers. The major task is making the stuff, of course, be it a sheet metal piece-part or a large subassembly.
But a few key aspects relate to valuation here. First, is the facility clean or dirty; bright or dim; organized or a mess? Curb appeal matters for companies, too. It’s human nature, because we all read a lot into what we see. Successful lean initiatives can be very attractive.
Also, some feel their value proposition is identical to the machinery and equipment (M&E) they deploy. Is it? Or is the deployed M&E a result of a well-defined value proposition set? A company that has modern and appropriate equipment generally will be valued higher since the owner or buyer will not have to shell out a lot of money to replace old, failing M&E. That money usually is deducted from the base valuation.
Besides this, though, I can tell you from my own experiences buying and selling manufacturers that unless the M&E is custom-made or a trade secret, then it generally is ignored when it comes to valuation. These machines provide no sustainable competitive advantage if others can buy them for the same purpose. So, is M&E glue? Only if it directly supports the value proposition—not if it is the value proposition.
Various other parameters—everything from legal and regulatory issues to certifications and licenses—affect valuation. Individually, they usually are not huge valuation issues, but in combination they could be.
For those of you who have stuck with this series on valuation, I hope you have noted that most of the parameters are interrelated. That’s not surprising. I also hope you have seen the benefit of managing with valuation in mind. So, devise your own valuation metric set. It really works.