More than numbers drive valuation -- much more
It’s about how the numbers became the numbers
Various factors drive company valuation, and one of the most significant is the market characteristics--that is, a company’s sources of revenue and the total available revenue within the company’s reach.
In the prior two columns I discussed the valuation of private companies, the importance of company size, and the various measures of profitability and asset utilization. These parameters determine some baseline company value as viewed by prospective buyers. They also influence the size of the pool of prospects who may view the company as attractive. The larger the pool—that is, the larger the market of buyers—the better the company’s actual realizable value is. That’s the thinking, and in general it is true.
But like everything else, there are nuances, and for privately owned custom fabricators, there are a lot of them. It’s not just about company size and the financials—we assume that they are factual. The real questions relating to realizable value are:
- What are the factors that made the numbers what they are?
- What is the likelihood of changes in those factors in the future?
- How will future cash flows be affected if or when the factors change?
A company’s realizable value is a function of future cash flows, adjusted for risk. The factors in question essentially determine that risk.
Behind the Numbers
Many question the quality of the numbers—that is, to what extent the numbers help when making future projections. Some financials appear attractive but are not likely to be sustainable. For instance, the numbers may be boosted by revenue from a large, one-time-only project unlikely to be replaced when that project ends.
Depending on the cost accounting system used, larger-than-normal inventory builds can increase pretax profits, sometimes called inventory profits. I call them borrowed profits, because when inventories fall to normal levels, the pretax profits take a hit. Of course, increasing inventories alone also causes unfavorable changes to cash, asset turns, and return on assets. Public companies often resort to this if they need to dress up for a sale or improve reported numbers.
Sometimes the numbers reflect reduced pricing to secure a large customer, boosting sales. This adversely affects overall gross margins, but it also can improve pretax profits if the rest of the business continues to produce normal or above-normal margins. There are many, many cases where that doesn’t happen.
This is why we need to examine the quality of the numbers carefully. Due diligence is necessary for buyers. It is also a powerful tool for driving real improvement internally. Of fundamental importance is a strong, regular, unbiased examination of factors that drive the company’s numbers. So what are these factors? There are many, but they fall into these categories:
- The market characteristics. These include sources of revenue and total available revenue within the company’s reach; number of prospective customers; how deeply and profitably the company has penetrated the market; the market’s growth outlook; and the threats that exist, everything from competitors to technological change.
- The company’s value propositions and fulfillment means. This differentiates the company, why customers choose it over others. This also entails the company’s ability to fulfill value propositions (operational effectiveness). Included in this category is the quality of the company’s human capital.
- Regulatory, legal, governmental, and certification issues. This includes OSHA or EPA matters; lawsuits against the company; and whether a company has certifications such as ISO 900x.
This column examines the first of these—the crucial market characteristics.
Sources of Revenue
What are your company’s sources of revenue? Who are your customers? How many do you have? How many make up half of your sales? In the answer to all of these questions, more is better. And the better known and respected the top customers are, the better they are for valuation—depending, of course, on how well and profitably you serve them.
Many in custom fabrication depend on three or even fewer customers for the great majority of revenue; often it’s more than 60 percent. This is viewed, rightfully, as a large risk. Also important is customer turnover, or the rate at which old customers leave and new customers are gained. This is not just a valuation metric. In my judgment, it is an extraordinarily important operational metric for gauging the effectiveness of the company’s operational value propositions, as well as its sales and marketing efforts.
People also want to know the size and makeup of the market for the company’s services; that is, current and potential customers in the geographic area that the company can economically reach. Who’s there? Is the market growing or contracting? How does the company touch them? How and by whom are they currently being served? What prevents the company from attaining a major supplier role with customers it doesn’t have? A mediocre company serving a vibrant, growing market often can be valued more than a well-performing company in a stagnant or declining market.
Finally, how does your company go to market and service customers and prospects? How does your company find and touch prospects, who does it, how are they compensated, and what are their exact roles and tasks? In other words, what talent and resources does senior management devote to the fundamental task of securing future revenue?
Threats to Revenue
Just as smart managers spend a lot of time on the current and prospective sources of current revenue, they also focus a lot of energy on the threats to that revenue. I believe this is what keeps private company owners up at night. It sure did for me. And this is the place where prospective buyers—who, again, set the realizable value of the company—often drill the hardest. The reason is simple: A lot can go wrong. And since revenue is the sine qua non for all companies, it receives a lot of attention. The focus points here include:
- Competitor density. How many exist in the company’s available market, what are their value propositions and characteristics, and what are their relative size and market position? Dismissing the competition as a bunch of knuckleheads who will be out of business in a year doesn’t work well. One had better know who they are, what their strengths are, and how to beat them. Obviously, high competitor density adversely affects revenue and margins and, thus, valuation. But intimate knowledge of competitors and their traits tends to offset the value degradation.
- Customers. What are the risks that the company may lose all or a significant portion of one or more of its major revenue sources? Buyer prospects are, and owners and managers should be, skeptical about any assertion that longtime customers will remain longtime customers, and that they will continue to provide the same levels of business.
We should not assume anything about the longevity of current business levels from current customers. Although that longevity is more often the fact in this business, there are too many cases in the past where it wasn’t, and won’t be in the future. Why? A lot of things can happen. A competitor may offer ridiculous prices. Major customers can undergo senior management changes that can affect sourcing decisions for any number of reasons. They may move or exit from product lines we thought were sacred, or adapt new technologies that have a profound impact on current business.
- Technological change. The constant changes in technology have significant effects, positive and negative, on available revenue for custom fabricators. (The focus here is on external change. I’ll discuss fabricating technology as related to operations in the next column.)
Positive effects from technological change abound. Consider the energy sector, which now demands various parts for new technologies, from new drilling methods to alternative energy. Negative effects of technological change abound too. Consider the vast improvement in machining accuracy and sensor/controller technology. These allow higher-power equipment in smaller enclosures with fewer supports—parts and assemblies often built by custom fabricators.
Smart companies, large and small, have their own technology roadmaps that help them gauge possible changes to their revenue stream. Prospective buyers want to know that too.
Tough Questions, Enlightening Answers
The valuation process requires tough questions, for sure. But answering them honestly can be enlightening. Valuation has a large component tied to both current and future revenue levels. When companies are being valued—either externally to set an offering price or internally to set valuation metrics as a basis for improvement—the future prospects for revenue gets the most attention. Asking and honestly answering these difficult revenue questions now will prevent a ton of pain and disappointment later.
The FABRICATOR is North America's leading magazine for the metal forming and fabricating industry. The magazine delivers the news, technical articles, and case histories that enable fabricators to do their jobs more efficiently. The FABRICATOR has served the industry since 1971.