What, exactly, drives long- (and short-) term value?
January 18, 2013
Columnist Dick Kallage explains why a private company should be interested in establishing its market value even if it isn't for sale.
We all know the daily valuation of public companies. It’s the stock price per share multiplied by the number of shares owned by investors. We also have opinions on the short-term pressures put on public company managers to meet quarterly numbers to support the stock price. Most of these opinions are not too favorable.
One of the significant advantages of being a private company is that owners and managers can, in principle, better balance the short term with the long term. They can make long-term investments in market development, equipment and technology, people, and infrastructure that may degrade short-term earnings but improve long-term performance. Most of us think this is a very good thing.
But what is the market value of the private company? Actually, we don’t know exactly. Frankly, if we’re not selling the business, should we even care? I believe we should. And as we shall see, managing for valuation is highly compatible with managing to a company strategy.
Why Valuation Matters
Every business I have run, be it a stand-alone private company or a division of a private or public company, has had a valuation component attached to its overall performance metric set. This component (actually an amalgam of several components) provided a view of the probable value range for the enterprise.
Valuation is related to the value of the future-risk-adjusted cash flows that the company can generate. As a manager, my goal was to increase that value over the short and long term (up to five years). The balance between short and long term depended on the current situation and the desires of the owners.
Managing for valuation and having a measure of valuation can provide a very strong unifier and clarifier for policy and strategy, decision-making, and execution. The trick is to devise the measure.
There is another reason for managing for valuation. At some point every company will change majority ownership. With public companies, it is a constant churn of minority owners or a sale of the outstanding stock to another company. With private companies, there is no constant churn; still, the owners will sell either their stock or the assets of the enterprise to another individual, individuals, or company. At this point the current owners are obviously looking to receive the maximum value for their stock or assets.
Company valuation is particularly pertinent in devising an overall improvement strategy. It is also timely. The reason is right in front of us. Baby boomers, who own a significant segment of the contract fabrication and general metalworking space, are nearing retirement. A lot of companies will be on the market during the next five years.
Some will be sold at a satisfactory price, but many will not. It probably will be a buyers’ market, where only the most attractive companies will realize a full value price in the eyes of the seller. Unfortunately, others will be forced to settle for a much lower-than-sought price. Or they may hold on to the company until it becomes attractive to buyers or the market dynamics change.
So what makes a private contract metal fabrication company attractive? And is that attractiveness compatible with solid day-to-day, year-to-year management and execution practices, as if the current owners would hold the company forever? Let’s take a look.
Factors of Valuation
First, here’s a caveat. Private companies can be very tricky to value within a narrow range. There is no broad stock market of liquidity that allows constant bidding and selling. That means the value is strictly in the eyes of a very narrow range of bidders who may view the value of the same company very differently. However, the consensus on the parameters that drive valuation is fairly broad:
When exploring a possible purchase, bidders weigh these factors to generate an overall valuation modifier number that accounts for risk. They then plug this into their proprietary model (which could be anything from a formal mathematical calculation to something rattling in the buyer’s head). From this comes a number—the amount a given buyer is willing to pay.
Looking at these parameters, we should not be surprised that they are very similar (actually, almost identical) to the factors we gauge to measure current, ongoing business. The only difference is the weight we may give each factor. Some are more important than others, depending on the time the measurements are taken. If the company will be sold during the next 12 months, sales level and the level of profitability are of primary importance. If there is no plan to sell in the next few years, market expansion or customer diversification may be primary.
This month we’ll focus on business size, the simplest factor to analyze. Future columns will address the others in detail. Note that business size may not be the overriding determinant of value. The others, individually or in combination, play a major role as well—often the major role.
Analyzing Business Size
Size does matter. It matters a lot. Virtually all potential buyers put a high weight on company size as measured by average revenue over the past three to five years. There seems to be several inflection points with regard to how metal fabricators and similar companies are valued. These include less than $5 million in annual revenue; $5 million to about $10-$12 million; $10-$12 million to $20-$25 million; and more than $25 million.
A company with, say, $11 million in average annual sales and another company with $3 million in average sales may have exactly the same pretax profit (PTP) or EBITDA percentage of sales. Regardless, though, the multiplier of PTP or EBITDA amount (a common shorthand method of describing the actual valuation) for the $11 million company will be higher.
Let’s say company A has sales of $3 million and EBITDA of $300,000, while company B has sales of $11 million and EBITDA of $1.1 million. Both company’s EBITDAs are 10 percent of sales. We have reviewed both companies and found the weighted parameters to be very similar. What could the companies expect for valuation? Company A could expect a valuation of between $600,000 and $900,000 (equivalent multiplier of between 2 and 3), while company B could expect a valuation between $3.85 million and $5.5 million (effective multiplier of between 3.5 and 5).
Why? It’s simply a matter of how buyers perceive risk. The larger the company, the less risk to future cash flows projected in the analysis. All other factors being equal, size matters in valuation, and it shows in the equivalent multiples of earnings a buyer will pay.
What are the implications for contract fabricators? Obviously, it’s good to get over the $5 million or $10 million hurdle if possible. If it’s not possible or desirable to grow to that size, then focusing on PTP or EBITDA percentage is critical to maximizing value.
Here is another good reason to get over the $5 million hurdle: Below this level, the pool of qualified buyers—that is, they have the cash—gets smaller. There is a class of potential buyers of industrial businesses who will not consider buying a company with less than $5 million in annual revenue (except for a technology or market capture play). Their reasons include risk, as noted previously, as well as the costs (relative to the transaction size) of due diligence, negotiation, and closing.
Next month we’ll cover the financials—what those numbers really mean and what to do about them.
The Fabricators & Manufacturers Association Intl. has launched a Strategy and Valuation Committee of FMA’s Management Advisory Council. This committee is tasked with exploring marketing and operational strategies available to contract metal fabricators and similar companies to maximize long- and short-term business value. The committee is currently examining the valuation parameters summarized in this article.
The group comprises successful shop owners, general management and operations experts, an M&A lawyer experienced in transactions relevant to fabricators, and representatives from academia. The committee plans to give its first report next month at The FABRICATOR’s Leadership Summit in Tampa, Fla. For more information, contact FMA at 888-394-4362, or visit www.fmanet.org.