Value: Include how to determine the value of a Firm and how do you create value - Eric Doyle
Eric D. Doyle
MBA 651
Final Paper
How value is determined and created in firms
The value of the business consists of not just the Price (i.e., the amount to be paid for the business) but also the associated terms and the deal structure. Different values for a business can exist because of different operating assumptions, deal structures, payment terms, etc., not due to use of different valuation methods. A few of the value drivers are:
Future Performance
Financial Leverage
Financial Return expectations
Cash Flows
Deal Structure
Asset Type
Exit Strategy
These value drivers impact business value in many different ways as I have explained below.
1) Future Performance. Value of a business is dependent on its future performance, not on the past performance. History of the business is relevant to the extent it helps project the expected future performance in the hands of a new Buyer. Future performance of the business depends upon the current condition of the business and what the new Buyer can and/or wants to do with the business. Therefore, values of a business will change depending upon the Buyer and his or her expectations.
2) Financial Leverage. Value of a business is dependent on the post-acquisition financial leverage. Higher financial leverage, generally associated with high asset base, means lower average cost of capital and hence higher value. A business with low financial leverage (generally associated with a low asset base, or an asset base with low borrowing capacity, or a tight lending market) will command a lower price due to lack of lower cost borrowing. Such businesses can command a respectable price if a cash flow lender can be found, or if the Seller is willing to finance the transaction. Financial leverage depends on the value of the assets, type of assets, size of the business, market conditions, credit worthiness of the Buyer, quality of earnings, post-acquisition management, etc.
3) Financial Return Expectation. Value of a business is dependent on the Buyer’s expected financial return. The higher the Return on Investment (ROI) expectation of the Buyer, the lower the business value. Some of the factors increasing the Buyer’s ROI expectation, and hence decreasing business value, are poor quality financials, up/down sales history, unpredictable and/or uncontrollable profit margins, lack of management, narrow product line or customer base, concentration of customers, suppliers, distribution channels, etc. ROI expectations also depend upon the type of assets; for example, ROI expectations of a real estate property are lower than that for a business property.
4) Cash Flow, Not Profits. Value of a business is dependent on cash flow, not profits. A business whose fixed assets base is high and/or requires high working capital is likely to require more of the profits to be reinvested back in the business, thus reducing the cash available for debt service. Hence, it would be valued lower. The opposite is true for a business with a low fixed assets base and/or with low working capital requirements; such businesses will be valued higher due to low reinvestment needs. (Note: A high assets business increases valuation because it provides more financial leverage, but at the same time it lowers valuation because the higher asset base generally requires higher reinvestment of profits.)
5) Deal Structure. Value of a business is dependent on the deal structure. Deal structure changes the taxes and the debt service of the transaction. In most cases, “all cash” value is going to be lower than the one with Seller Financing due to higher cost of capital associated with equity.
6) Asset Type. Value of a business depends on the type of assets used in the business. The type of assets impacts lender advance rates and the depreciation life of the assets, which in turn impacts value of the business.
7) Exit Strategy. Value of the business depends on the exit strategy of the Buyer. A component of the cash flow to the Buyer is the amount that would be realized at the end of the planning horizon as if the business were sold at that time. Therefore, the value of the business today depends on the value of the business at the end of the planning horizon. Most Buyers make the assumption that the Exit Price Multiple (EM) will be the same as the Purchase Price Multiple (PM). However, many Buyers assume EM to be higher than the PM if they are consolidating an industry or are planning to go public. Similarly, a Buyer may assume a lower EM than the PM if the growth beyond the planning horizon is going to be lower than the growth during the planning horizon.
It is also important to remember that business value is an informal concept and there is no consensus, either in academic circles or among management professionals, on its meaning or role in effective decision-making. The term could even be described as a buzz word used by various consultants, analyst firms, executives, authors, and academics. Some critics believe that measuring economic value, economic profit, or shareholder value is sufficiently complete to guide decision-making. Their logic is that all other forms of value are essentially intermediate to the ultimate goal of economic profit. Furthermore, if they do not contribute to economic profit, they are actually a distraction for the firm. Other critics believe that extensive efforts to measure business value will be more of a distraction than a boon. For example, there is a fear that decision-makers will be confused if there are too many goals and measures that need to be accommodated.
When it comes to creating value we must all recall Porters Value Chain. How does your organization create value? How do you change business inputs into business outputs in such a way that they have a greater value than the original cost of creating those outputs? This isn't just a dry question: it's a matter of fundamental importance to companies, because it addresses the economic logic of why the organization exists in the first place.
Manufacturing companies create value by acquiring raw materials and using them to produce something useful. Retailers bring together a range of products and present them in a way that's convenient to customers, sometimes supported by services such as fitting rooms or personal shopper advice. And insurance companies offer policies to customers that are underwritten by larger re-insurance policies. Here, they're packaging these larger policies in a customer-friendly way, and distributing them to a mass audience. The value that's created and captured by a company is the profit margin: Value Created and Captured – Cost of Creating that Value = Margin
The more value an organization creates, the more profitable it is likely to be. And when you provide more value to your customers, you build competitive advantage. Understanding how your company creates value, and looking for ways to add more value, are critical elements in developing a competitive strategy. Michael Porter discussed this in his influential 1985 book "Competitive Advantage," in which he first introduced the concept of the value chain.
A value chain is a set of activities that an organization carries out to create value for its customers. Porter proposed a general-purpose value chain that companies can use to examine all of their activities, and see how they're connected. The way in which value chain activities are performed determines costs and affects profits, so this tool can help you understand the sources of value for your organization. Rather than looking at departments or accounting cost types, Porter's Value Chain focuses on systems, and how inputs are changed into the outputs purchased by consumers. Using this viewpoint, Porter described a chain of activities common to all businesses, and he divided them into primary and support activities, as shown below.
Primary activities relate directly to the physical creation, sale, maintenance and support of a product or service. They consist of the following:
Inbound logistics – These are all the processes related to receiving, storing, and distributing inputs internally. Your supplier relationships are a key factor in creating value here.
Operations – These are the transformation activities that change inputs into outputs that are sold to customers. Here, your operational systems create value.
Outbound logistics – These activities deliver your product or service to your customer. These are things like collection, storage, and distribution systems, and they may be internal or external to your organization.
Marketing and sales – These are the processes you use to persuade clients to purchase from you instead of your competitors. The benefits you offer, and how well you communicate them, are sources of value here.
Service – These are the activities related to maintaining the value of your product or service to your customers, once it's been purchased.
There are also activities to support the primary functions above. I have them listed here.
Procurement (purchasing) – This is what the organization does to get the resources it needs to operate. This includes finding vendors and negotiating best prices.
Human resource management – This is how well a company recruits, hires, trains, motivates, rewards, and retains its workers. People are a significant source of value, so businesses can create a clear advantage with good HR practices.
Technological development – These activities relate to managing and processing information, as well as protecting a company's knowledge base. Minimizing information technology costs, staying current with technological advances, and maintaining technical excellence are sources of value creation.
Infrastructure – These are a company's support systems, and the functions that allow it to maintain daily operations. Accounting, legal, administrative, and general management are examples of necessary infrastructure that businesses can use to their advantage.
Companies use these primary and support activities as "building blocks" to create a valuable product or service. To identify and understand your company's value chain, follow these steps.
Step 1 – Identify sub-activities for each primary activity. For each primary activity, determine which specific sub-activities create value. There are three different types of sub-activities:
Direct activities create value by themselves. For example, in a book publisher's marketing and sales activity, direct sub-activities include making sales calls to bookstores, advertising, and selling online.
Indirect activities allow direct activities to run smoothly. For the book publisher's sales and marketing activity, indirect sub-activities include managing the sales force and keeping customer records.
Quality assurance activities ensure that direct and indirect activities meet the necessary standards. For the book publisher's sales and marketing activity, this might include proofreading and editing advertisements.
Step 2 – Identify sub-activities for each support activity. For each of the Human Resource Management, Technology Development and Procurement support activities, determine the sub-activities that create value within each primary activity. For example, consider how human resource management adds value to inbound logistics, operations, outbound logistics, and so on. As in Step 1, look for direct, indirect, and quality assurance sub-activities. Then identify the various value-creating sub-activities in your company's infrastructure. These will generally be cross-functional in nature, rather than specific to each primary activity. Again, look for direct, indirect, and quality assurance activities.
Step 3 – Identify links. Find the connections between all of the value activities you've identified. This will take time, but the links are key to increasing competitive advantage from the value chain framework. For example, there's a link between developing the sales force (an HR investment) and sales volumes. There's another link between order turnaround times, and service phone calls from frustrated customers waiting for deliveries.
Step 4 – Look for Opportunities to Increase Value. Review each of the sub-activities and links that you've identified, and think about how you can change or enhance it to maximize the value you offer to customers (customers of support activities can internal as well as external).
- Eric Doyle
Eric D. Doyle
MBA 651
Final Paper
How value is determined and created in firms
The value of the business consists of not just the Price (i.e., the amount to be paid for the business) but also the associated terms and the deal structure. Different values for a business can exist because of different operating assumptions, deal structures, payment terms, etc., not due to use of different valuation methods. A few of the value drivers are:
These value drivers impact business value in many different ways as I have explained below.
1) Future Performance. Value of a business is dependent on its future performance, not on the past performance. History of the business is relevant to the extent it helps project the expected future performance in the hands of a new Buyer. Future performance of the business depends upon the current condition of the business and what the new Buyer can and/or wants to do with the business. Therefore, values of a business will change depending upon the Buyer and his or her expectations.
2) Financial Leverage. Value of a business is dependent on the post-acquisition financial leverage. Higher financial leverage, generally associated with high asset base, means lower average cost of capital and hence higher value. A business with low financial leverage (generally associated with a low asset base, or an asset base with low borrowing capacity, or a tight lending market) will command a lower price due to lack of lower cost borrowing. Such businesses can command a respectable price if a cash flow lender can be found, or if the Seller is willing to finance the transaction. Financial leverage depends on the value of the assets, type of assets, size of the business, market conditions, credit worthiness of the Buyer, quality of earnings, post-acquisition management, etc.
3) Financial Return Expectation. Value of a business is dependent on the Buyer’s expected financial return. The higher the Return on Investment (ROI) expectation of the Buyer, the lower the business value. Some of the factors increasing the Buyer’s ROI expectation, and hence decreasing business value, are poor quality financials, up/down sales history, unpredictable and/or uncontrollable profit margins, lack of management, narrow product line or customer base, concentration of customers, suppliers, distribution channels, etc. ROI expectations also depend upon the type of assets; for example, ROI expectations of a real estate property are lower than that for a business property.
4) Cash Flow, Not Profits. Value of a business is dependent on cash flow, not profits. A business whose fixed assets base is high and/or requires high working capital is likely to require more of the profits to be reinvested back in the business, thus reducing the cash available for debt service. Hence, it would be valued lower. The opposite is true for a business with a low fixed assets base and/or with low working capital requirements; such businesses will be valued higher due to low reinvestment needs. (Note: A high assets business increases valuation because it provides more financial leverage, but at the same time it lowers valuation because the higher asset base generally requires higher reinvestment of profits.)
5) Deal Structure. Value of a business is dependent on the deal structure. Deal structure changes the taxes and the debt service of the transaction. In most cases, “all cash” value is going to be lower than the one with Seller Financing due to higher cost of capital associated with equity.
6) Asset Type. Value of a business depends on the type of assets used in the business. The type of assets impacts lender advance rates and the depreciation life of the assets, which in turn impacts value of the business.
7) Exit Strategy. Value of the business depends on the exit strategy of the Buyer. A component of the cash flow to the Buyer is the amount that would be realized at the end of the planning horizon as if the business were sold at that time. Therefore, the value of the business today depends on the value of the business at the end of the planning horizon. Most Buyers make the assumption that the Exit Price Multiple (EM) will be the same as the Purchase Price Multiple (PM). However, many Buyers assume EM to be higher than the PM if they are consolidating an industry or are planning to go public. Similarly, a Buyer may assume a lower EM than the PM if the growth beyond the planning horizon is going to be lower than the growth during the planning horizon.
It is also important to remember that business value is an informal concept and there is no consensus, either in academic circles or among management professionals, on its meaning or role in effective decision-making. The term could even be described as a buzz word used by various consultants, analyst firms, executives, authors, and academics. Some critics believe that measuring economic value, economic profit, or shareholder value is sufficiently complete to guide decision-making. Their logic is that all other forms of value are essentially intermediate to the ultimate goal of economic profit. Furthermore, if they do not contribute to economic profit, they are actually a distraction for the firm. Other critics believe that extensive efforts to measure business value will be more of a distraction than a boon. For example, there is a fear that decision-makers will be confused if there are too many goals and measures that need to be accommodated.
When it comes to creating value we must all recall Porters Value Chain. How does your organization create value? How do you change business inputs into business outputs in such a way that they have a greater value than the original cost of creating those outputs? This isn't just a dry question: it's a matter of fundamental importance to companies, because it addresses the economic logic of why the organization exists in the first place.
Manufacturing companies create value by acquiring raw materials and using them to produce something useful. Retailers bring together a range of products and present them in a way that's convenient to customers, sometimes supported by services such as fitting rooms or personal shopper advice. And insurance companies offer policies to customers that are underwritten by larger re-insurance policies. Here, they're packaging these larger policies in a customer-friendly way, and distributing them to a mass audience. The value that's created and captured by a company is the profit margin: Value Created and Captured – Cost of Creating that Value = Margin
The more value an organization creates, the more profitable it is likely to be. And when you provide more value to your customers, you build competitive advantage. Understanding how your company creates value, and looking for ways to add more value, are critical elements in developing a competitive strategy. Michael Porter discussed this in his influential 1985 book "Competitive Advantage," in which he first introduced the concept of the value chain.
A value chain is a set of activities that an organization carries out to create value for its customers. Porter proposed a general-purpose value chain that companies can use to examine all of their activities, and see how they're connected. The way in which value chain activities are performed determines costs and affects profits, so this tool can help you understand the sources of value for your organization. Rather than looking at departments or accounting cost types, Porter's Value Chain focuses on systems, and how inputs are changed into the outputs purchased by consumers. Using this viewpoint, Porter described a chain of activities common to all businesses, and he divided them into primary and support activities, as shown below.
Primary activities relate directly to the physical creation, sale, maintenance and support of a product or service. They consist of the following:
Inbound logistics – These are all the processes related to receiving, storing, and distributing inputs internally. Your supplier relationships are a key factor in creating value here.
Operations – These are the transformation activities that change inputs into outputs that are sold to customers. Here, your operational systems create value.
Outbound logistics – These activities deliver your product or service to your customer. These are things like collection, storage, and distribution systems, and they may be internal or external to your organization.
Marketing and sales – These are the processes you use to persuade clients to purchase from you instead of your competitors. The benefits you offer, and how well you communicate them, are sources of value here.
Service – These are the activities related to maintaining the value of your product or service to your customers, once it's been purchased.
There are also activities to support the primary functions above. I have them listed here.
Procurement (purchasing) – This is what the organization does to get the resources it needs to operate. This includes finding vendors and negotiating best prices.
Human resource management – This is how well a company recruits, hires, trains, motivates, rewards, and retains its workers. People are a significant source of value, so businesses can create a clear advantage with good HR practices.
Technological development – These activities relate to managing and processing information, as well as protecting a company's knowledge base. Minimizing information technology costs, staying current with technological advances, and maintaining technical excellence are sources of value creation.
Infrastructure – These are a company's support systems, and the functions that allow it to maintain daily operations. Accounting, legal, administrative, and general management are examples of necessary infrastructure that businesses can use to their advantage.
Companies use these primary and support activities as "building blocks" to create a valuable product or service. To identify and understand your company's value chain, follow these steps.
Step 1 – Identify sub-activities for each primary activity. For each primary activity, determine which specific sub-activities create value. There are three different types of sub-activities:
Direct activities create value by themselves. For example, in a book publisher's marketing and sales activity, direct sub-activities include making sales calls to bookstores, advertising, and selling online.
Indirect activities allow direct activities to run smoothly. For the book publisher's sales and marketing activity, indirect sub-activities include managing the sales force and keeping customer records.
Quality assurance activities ensure that direct and indirect activities meet the necessary standards. For the book publisher's sales and marketing activity, this might include proofreading and editing advertisements.
Step 2 – Identify sub-activities for each support activity. For each of the Human Resource Management, Technology Development and Procurement support activities, determine the sub-activities that create value within each primary activity. For example, consider how human resource management adds value to inbound logistics, operations, outbound logistics, and so on. As in Step 1, look for direct, indirect, and quality assurance sub-activities. Then identify the various value-creating sub-activities in your company's infrastructure. These will generally be cross-functional in nature, rather than specific to each primary activity. Again, look for direct, indirect, and quality assurance activities.
Step 3 – Identify links. Find the connections between all of the value activities you've identified. This will take time, but the links are key to increasing competitive advantage from the value chain framework. For example, there's a link between developing the sales force (an HR investment) and sales volumes. There's another link between order turnaround times, and service phone calls from frustrated customers waiting for deliveries.
Step 4 – Look for Opportunities to Increase Value. Review each of the sub-activities and links that you've identified, and think about how you can change or enhance it to maximize the value you offer to customers (customers of support activities can internal as well as external).