For the past 20 years our core clients have been crying about the lack of available talent, particularly for knowledge-based positions. Now, faced with the most impressive available talent pool in years, they are all tightening their belts, afraid to act, afraid to invest. Worse, they routinely quote the garbage that populates the various populist sites, such as Yahoo homepage, Marketwatch opinion pieces, etc., including all sorts of ridiculous ideas and rules of thumb that even naive children should recognize as complete and utter dross.
Newsflash: all other things equal, a salesperson with experience and contacts will sell more than one without. How about this one: getting laid off from a firm that goes under (presuming you are not directly responsible for the failure) does not in any way impact your credentials or skill set. Both of these were directly contradicted by recent Yahoo "news" articles allegedly written by, or resulting from interviews with, HR professionals. If true, those alleged HR professionals themselves should be reviewed and most likely discharged.
Talent is talent. There are two indications of talent - successful application thereof, i.e. relevent, successful experience, and the intrinsic skills that are necessary conditions for such success. Talent doesn't always generalize - in fact, it rarely does, so being able to sell retail goods is not the same as being able to sell industrial parts. Being able to sell yourself in a job interview is not the same as being able to sell industrial parts. That doesn't mean that there aren't instances where the skills are similar and performance can generalize, just that there is no reason to think it will necessarily be so. So if a high-performing electronics parts salesperson isn't an instant success at selling timeshares in a down economy, that doesn't disqualify them for an opening in electronic parts sales. Seems obvious, but the brain trust responsible for the "rules of thumb" articles don't seem to get that. 1) They think that being available for work is an intrinsic liability. 2) They seem to think that someone willing to take a chance on a new career direction is worth less than someone who wouldn't. 3) They seem to believe that anyone attempting to change industries is a poor candidate for all industries. Let's explore an example - "Jim", a top performer at "Monolithic Defense Sales" decides to join a startup with a couple of his peers selling "widgets", a new product invented by one of the partners, which is supposed to increase efficiency of heating systems in homes. They all have substantial savings because they were all talented managers at "MDS", and their contacts were strong enough that they weren't terribly worried about stepping back from entrepreneur land should their best laid plans fail. Alas, efficient heating units are not the super consumer draw they thought, and the business fails, but not until they have invested most of their savings and almost two years of their efforts into the company. They are now much worse off, and "Jim" is defaulting on his credit card debt, but now looking for a job back in the defense industry. Another news flash: Jim is a damn goldmine for the right company. He is talented, he is current enough with technologies for sales, he isn't afraid of a little risk, and he is hungry. He is more than willing to take a slightly lower base than he deserves, as long as the commissions will ultimately make up for it and he has the support and patience of management to establish a new book of business. Alas, he never gets the chance because the brain trust believes that he is "un-hireable" because he: a) has been looking for a job unsuccessfully for 6 months, b) failed to sell in his current position, c) took a job that was at best lateral, and likely downward, and d) (although they won't say it directly ) is too old. Better to hire a green idiot two years out of school according to the brain trust... cheaper, more current on technology, and more likely to succeed. Not a chance. Look - when economics turn in your favor you don't start questioning all the awesome opportunities that come your way - you thank your lucky stars and take advantage of each and every gift. Jim is a gift. He is a rare, wonderful gift who can rock your world. You may need to work a little harder on setting up incentive structures, be prepared to have a little push-back on areas where you are weak, and you are less likely to have a nodding lemming on your staff, but assuming creativity and experience count in your industry, he will outperform the newbies 9 out of 10 times. Yes, you may pay a bit more in total, but on a "per sales dollar generated" metric Jim is your salvation. Oh, and about that credit report thing - struggling to stay afloat, and seeking a job while doing so is not a negative towards employment. It shows confidence, more often than not. People who are talented are sure they will find employment, so they live a little riskier while they are "between". Sometimes that credit issue should be read as a positive.
"I never read resumes that are more than two pages". Then you are an idiot. Look - it might make sense to stop reading after the second page, but discarding the resume because someone is experienced is nuts! No, 20-year old experience in a completely different job may not be relevent, but it doesn't hurt. It doesn't make the current skillset less valuable. Are you hiring a resume writer, or is this position focused elsewhere? Yes, there are poorly written resumes that often portend poor communications skills. There are also wonderful resumes from wonderful candidates that are simply not trendy. Unless you are paying top dollar you will not hire perfect people. It's OK to take a few flaws in amongst the strengths, and if the main flaw you have found is that the guy is proud of his past, and puts his entire history on display for you, don't toss it - ignore it if you must, but for Pete's sake, take a look. Had the green newbie listed the entirety of his career (which he might have, despite the brevity), it would doubtlessly include a recent stint at a burger joint, some babysitting, and work-study tutoring. Compared to Jim's useless clerical job in the marketing department, give the edge to Jim. Knowing how things work in the real world trumps burping skills every time.
About those HR "experts" - take a minute to read between the lines. More often than not the articles are focused on circumventing the law and justifying unethical acts. Age discrimination is illegal, but note that if you follow their advice and ask the questions "just so" you can sneak out information that would enable you to make illegal hiring decisions without fear of repercussions. Good HR people don't toss out good talent, and don't focus their efforts on unethical acts. Instead, they focus on motivation, on clarity of communication, on setting appropriate expectations, and most importantly, on helping firms optmize their workforces to get the most performance, which generally correlates with the most satisfied staff. The last person you want advice from is the one advocating illegal or unethical acts, no matter how justified.
You should have hired Jim. One of your competitors just did. Jim has already had more sales meetings and follow-ups with new clients than the entire department did in the previous six months. Some of the support staff are a little annoyed that Jim is pushy and wants everything so fast. There are even grumbles amongst the other sales people that Jim is making them look bad. Most of them will continue grumbling, but a few will probably find some stones and get to work. Hiring Jim put a fire under the newbies who should never have been hired in the first place. It also woke up the older guys who now remember that they were Jim themselves once upon a time. Hire Jims. Stop reading "Ten things HR people advocate" articles. Or else you might want to start paring down your resume - two pages, that's the max.
Monday, March 28, 2011
Thursday, March 17, 2011
Back of the envelope - valuations that can be done on coffeeshop napkins
This post will outline some basic approaches to "back of the envelope" valuation techniques. These aren't really valuations - just structured guesses based on insufficient analysis. That's why most of this post will focus on the limitations and dangers of using shortcuts when due dilligence is called for. Nevertheless, simple approaches to thinking about value are essential tools - as prioritization devices if nothing else. There are three methods presented here - P/E or price/earnings, P/S or price/sales, and price/employee - which is trickier than it sounds.
For those who want the bottom line first, the simplest form of value calculation is bottom line ratios - for example, in some industries the average price earnings, or EBITDA ratio (price of the company divided by earnings before interest, tax, dividends and amortization) may be 5:1. If the company you are looking at has a higher ratio, it is either overpriced, includes a spurious earnings hit that the market has priced out, or is expected to grow faster than the industry on average. All other things equal, if you want to roughly compute the market value of a private firm in this industry, look at the EBITDA from the Income Statement, multiple by the industry average, and you should be in the ballpark. Similar ratios are price to sales (price of the company divided by gross sales), and my personal favorite: margin to market share(this one's complicated - it's an aggregation of the firm's profit margin, the firm's market share, and the general performance of the industry... all of which are readily available. In general, this ratio gives a weighted percentage of the overall industry value that should be attributed to this particular company). We will explain the first two of these in detail below, but they are all fundamentally rotten, and here's why: GAAP is a joke. GAAP stands for Generally Accepted Accounting Principles, which all businesses supposedly utilize. They don't. How and when you recognize sales matters for ratio calculation, but firms don't all do it the same way. If you contract for R&D versus running an inside lab as an independent wholly-owned entity your financial statements will differ, even if you spend the same amount. These are just examples, and there are many more available. Still, as a general measure of the direction of the wind, they are enough so long as they are understood in that context.
Theoretically, capital structure and organizational structure shouldn't matter to the value of an organization, but they do, and they impact earnings. Because of the I and T in EBITDA it isn't a very good surrogate for cashflow. Suppose two otherwise identical companies differ in that one owns $1 million worth of equiment outright, and either expensed or fully depreciated the asset, while the other owes $1 million to the bank at 10% interest. Personally, I'd like to pay $1 million dollars less for company B than A. A simple EBITDA ratio, however, would value the firms equally, and this is ridiculous. If a third company, otherwise equal, has been paying off a liability claim from a discontinued product line, and the last payment was made in the current reporting period, it will show a lower EBITDA than its peers. Worse, suppose a fourth company is about to start payments on a structured settlement that will persist for 5 years... an EBITDA ratio won't reflect the situation. The bottom line here is that while any or all of these circumstances can be ignored as being "unusual"... there are always unusual circumstances, so the generic valuation guidelines always have issues of some sort - only the scope and significance change. Caution must be your watchword as you proceed.
There are a bunch of basic business principles that form the core knowledge base upon which top-tier MBA's are built. When you sit through the lectures and mathematics during your first year of B-school you tend to accept these as "truths we hold to be self-evident". You then spend the second year trying to learn how to violate each and every one of the fundamental tenets - ethically, of course! With advance apologies - many of those who have studied the same tenets in lesser forums, such as on their own or at weaker schools, tend to get them almost completely wrong. If you do not understand the mathematics of Beta calculations, you might want to take Mr. Lincoln's advice when the subject comes up. Similarly, words like "hedge", "efficient markets", "information transparency", etc., have specific meanings that are not quite what the words suggest. It is important that you understand the specific meanings of numbers and formulas when you are doing valuation or else you might as well just guess. I'm about to frustrate most of the people reading this because I am going to start by giving you even more warnings about flaws as I walk through the definitions and concepts. Think of this as your lecture in shop safety - before you use the power tools make sure you aren't about to cut off your arm.
Most valuation methods are, at their core, based on DCF analysis, or discounted cash flow. Even the basic rule of thumb techniques ultimately are simply shorthand mechanisms for predicting the amount of cash that can be had through executing the processes of the analyzed business. So here come the caveats - the general case versions have way too many flaws to be taken seriously. Most of the value in DCF calculations comes from the terminal state calculations on the far right of the pro forma spreadsheets, which inevitably predict that the business will survive and prosper forever. Doesn't happen. Besides the Catholic church, name a company that's been in continuous operation for over 400 years (there are a few). OK - 20 years is generally a sufficient surrogate for forever in the calculations, but the point is that you need to understand the assumptions in order to use the generic tools. Now it is time for a reality check: do you understand discounting (if you answered 10% off at Ross - duh!, then you do not), pro forma, revenue, and profit? If you answered yes to all you also fail - seriously, what does profit mean without more context? More apologies, but before you turn on these power tools you need caution and knowledge.
If I give you a dollar now, it is worth more than if I give you a dollar next year, assuming that banks are still paying interest for savings accounts. If I offer to trade today dollars for future dollars you should accept the deal with no limit, put the today dollars in the bank, then pay me back next year and keep the interest. So the value of next year dollars is less than today dollars, and to compute how much less, I basically divide them by the interest rate I can receive on today's dollars, which is called discounting. The longer the time period, the lower the value of the future money. There are a few extremely rare exceptions - times when deflation occurs, but honestly they are rare enough and dangerous enough that you need not worry too much. (If a 1200-mile diameter meteor is about to strike the earth, you can stop worrying about the long-term impact of pesticides on your liver.) A business is basically a cash pump - you buy it or build it at a certain cost, then it pumps out money until the assets all break or are used up. Most businesses continually reinvest over their lifetimes, which makes everything more complicated. When you invest in a business or an asset you are paying a pile of today dollars in exchange for a stream of future dollars, so you value both and decide which is worth more to you. Today dollars are tangible, future dollars are speculative, so there should be an element of risk calculation in your assessment.
"Pro forma" is easy - the dollars in your pocket represent reality. The projection of what will happen after you invest them is the "pro forma" version - i.e. the analysis of the expected consequences of an investment (or any businesss action). If I have $1000 in my pocket, my current projections are that I will still have it five years from now (risk adjusted for robbery etc., it's probably worth a bit less than $1000). My current plan is to put it in the bank, so my pro forma income statement would reflect the pittance my bank would give me. If I invest it in my cousin's latest get-rich-quick scheme I will receive $300 per year for the next 4 years, then get back $1300, for a total of around $2580 (not an error - why?) future dollars, however ... (HUGE CAVEAT) ... there is only around 10% chance that this will actually happen, only a 50% chance that I will receive even the first payment, etc... so the risk adjusted future value would be around $320, which explains why I rarely invest in my cousin. If I put the money in my 401K I can expect on average to get the market return of 9%, but I have my doubts about the historical rate meaning much given the recent changes to the way that the financial markets function and are structured, so I would risk adjust that down to around 5%. In business plans you are presented with a pro forma view of the business, but like most people, you probably do not have a pro forma understanding of what happens if you do not invest, and you are even less likely to have a risk-adjusted pro forma view of both scenarios. So like everyone else, you compare tangible present dollars to intangible "wishfull thinking" dollars, neither of which reflects the truth about coming attractions.
Now on to profit... there are many different types of profit, and the one I care about is economic profit. Here are the differences: gross profit is the difference between the sales price and the cost of production of an item. If I buy a banana from Trader Joe for 19 cents and sell it for 30 cents I have a gross profit of 21 cents. If I spent 2 cents on gas, 2 cents on a telephone call to arrange the meeting, and paid myself 4 cents for labor (cost of sales not production) my profit before taxes, interest and depreciation (EBITDA) might be 13 cents. After taxes, depreciation on my car, interest on the car loan, etc., my net profit might be 3 cents. This would be pretty darned good compared to the real world - 44% Sales/EBITDA ratio, 10% Sales/Net ratio - If I compare this to an investment in Superfoods, I'd be an investor ... however ... I'm not a licensed banana seller, and I don't have a food server permit, and I left out a bunch of other stuff, so actually I am a high-risk business since I'm likely to be closed down fairly soon. Therefore, I'm entitled to more profit than a more compliant competitor. Further, it won't be long before another entrant sells bananas for a penny less, until such time as the profit stops being worth the risks - in other words competitors will drive the price down to the proper price whereat I am indifferent between the risk adjusted rewards of this business, and the risk adjusted rewards of the Superfoods business. Since the market will also drive the price of Superfoods down to the level where I am indifferent between it and an investment in CountyBank (for example), or any other company, then the excess profits will eventually be gone - i.e. unless I can constrain the market in some way, my profits are completely offset by the risks. Economic profit is the difference between the net profits and the average risk adjusted profits of a company in this industry. I want that. That means that all things considered and properly analyzed I am outperforming my alternatives. Woohoo. That kind of profit usually comes via monopoly, regulative constraint, uneven playing fields, massive size, or any of the other competitive levers you read about. It doesn't come from selling TJ bananas on the street, except maybe at midnight when TJs is closed and the regulators are asleep... and even then risk is usually correctly priced into the equation.
So let's put these ideas together - I'm thinking about buying a stable, non-growing company for $1 million which has an EBITDA of $100,000/year. I can get 4% interest from my bank, or 9% interest on average if I invest in the stock market and believe in fairies, so is it worth looking at? Corporate tax (which is different from and additive to individual income tax) is going to run around $40,000/year, so my net would be a maximum of $60,000 before accounting for risk, which puts it between the risk-free rate from the bank, and the average market rate. Since any company is intrinsically more risky than all companies collectively the market investment is preferable, so I'll pass. Get that EBITDA up to around $150,000/year and I start becoming interested - again with the caveat of the laundry list of cautions to check for. It still sucks because of the risk vectors, but it's at least becoming reasonable... i.e. I make as much as I would investing in the market as a whole. Therefore, I'm beginning to take notice of stable companies when their P/E ratio is 6.5:1 or less. If the company and/or market is declining, I need lower, and if the company and the market are growing (more or less in sync) I can tolerate a little more. How do I figure out if the market is growing and expected to keep growing? Look at the P/E for the industry as a whole - most of the time (another giant caveat) the junior, just-got-out-of-business-school analysts who compute and publish such things get the basic ratios right. In general, the bigger a company is, the less risky it's survival is, so in the case I described, I'd assess a pretty big risk factor, since a $1 million dollar company is basically an insignificant rounding error in comparison to most industries. So where do most companies sell? In or around 5:1, if the EBITDA is dependable, there are no strategic defenders of growth rates, and there are no giant gotcha's to worry about. If the company is offered at a P/E of 4:1 or less I would be darn sure to do my dilligence carefully - the incumbents know more about their company than you do, and if they are discounting it, figure out why.
Sounds easy right? Too bad it doesn't work that way. Small companies can pay their owners salary, or via dividends, or (not proper but regularly done) by paying the owner's expenses as business expenses, or in some cases, not pay the owners at all. EBITDA just doesn't translate as well as it should so we need alternate guidelines even on a high-level basis. Price to sales is another easy to compute ratio, so let's take a look at it.
Most small stable companies are valued at between one to two times their annual sales. Why? Because on average EBITDA is around 10-20% of sales, so net cashflow (assuming no debt) is around 6-12% of sales, so the company starts looking more interesting than the market as a whole at a 1.0 ratio when the margin is at the high end of that range, and at 2.0 when at the low end. Assuming a company is an average performer in its industry, it can expect an average margin, and the industry's price/sales ratio gives a good cross check for value. If I'm getting a lower ratio than the industry average, and everything looks kosher, woohoo. Again, a growing company in a growing market is entitled to a higher ratio since future cash flows should increase, and conversely, contracting companies or industries warrant (huge) discounts, or lower ratios.
What's wrong with this picture? Suppose I know I'm about to sell the company - it's time to offer discounts to all my customers to entice them to place advance orders. It'll screw my future earnings ratio, but it'll pump my current sales. If I'm smart, and not terribly ethical, I decrease my draw at the same time. This keeps my margins the same as historical averages, increase my sales, and suggests that I'm growing - all three of which look nice on the basic ratios, but it's not a sustainable situation. When I outline this in the context of a small business preparing to sell itself you might whisper "for shame" under your voice and perhaps even shake your head slightly when looking at me. Take a look at the books of banks that fail, or huge companies that suddenly file for Chapter 11 and you will see all sorts of creative techniques for painting rosy pictures in the hope that things will change for the better before anyone takes serious notice. So the caveat reads something like this: start with P/E, validate the basic calculation by taking a look at Price/Sales, then if you are still interested, go deep into the discretionary numbers to make sure they weren't rigged in a gross manner. Assuming you're still interested, throw it all away and do a real valuation since by now you should be willing to sign an NDA and get serious with the source data of the target company.
If you made it to here, you deserve a special treat, and that's what the price/employee ratio is. I care a lot about the sales/employee ratio in companies. It tells you a little about efficiency, and a lot about strategic positioning. Companies that are low-price competitors have extremely high ratios of sales to employees, whereas high-brow firms tend towards the other extreme. I expect gross margins (not EBITDA or net margins) to go in the opposite directions - order takers generate smaller margins than salesmen, but they move more product. At a minimum, this ratio can be used to cross-check the other ratios - if the company strategy is skewed one way or another from the general industry then the ratio should reflect this, and the ratio of EBITDA to gross margin should also reflect this (high-touch sales are more expensive than order taking). However, this ratio also indicates growth and performance potential of the firm - high efficiency firms are not likely to gain improved margins, but low efficiency firms with decent margins have a strong upside. Couple this to the price function, and you get a good assessment of the assets you are buying - if you are paying a lot per person, but the people are commodities in terms of function, then the price is too high. Conversely, inexpensive quality employees are a wonderful asset to discover. This ratio is not generic across industries, so there are no basic rules of thumb, but it is an easy to compute ratio that has a lot of potential to improve your understanding of the firm value, so do it.
In the next post we will dig into cash flow, which will provide support and insight into the guts of the firms and make the course estimates more meaningful.
For those who want the bottom line first, the simplest form of value calculation is bottom line ratios - for example, in some industries the average price earnings, or EBITDA ratio (price of the company divided by earnings before interest, tax, dividends and amortization) may be 5:1. If the company you are looking at has a higher ratio, it is either overpriced, includes a spurious earnings hit that the market has priced out, or is expected to grow faster than the industry on average. All other things equal, if you want to roughly compute the market value of a private firm in this industry, look at the EBITDA from the Income Statement, multiple by the industry average, and you should be in the ballpark. Similar ratios are price to sales (price of the company divided by gross sales), and my personal favorite: margin to market share(this one's complicated - it's an aggregation of the firm's profit margin, the firm's market share, and the general performance of the industry... all of which are readily available. In general, this ratio gives a weighted percentage of the overall industry value that should be attributed to this particular company). We will explain the first two of these in detail below, but they are all fundamentally rotten, and here's why: GAAP is a joke. GAAP stands for Generally Accepted Accounting Principles, which all businesses supposedly utilize. They don't. How and when you recognize sales matters for ratio calculation, but firms don't all do it the same way. If you contract for R&D versus running an inside lab as an independent wholly-owned entity your financial statements will differ, even if you spend the same amount. These are just examples, and there are many more available. Still, as a general measure of the direction of the wind, they are enough so long as they are understood in that context.
Theoretically, capital structure and organizational structure shouldn't matter to the value of an organization, but they do, and they impact earnings. Because of the I and T in EBITDA it isn't a very good surrogate for cashflow. Suppose two otherwise identical companies differ in that one owns $1 million worth of equiment outright, and either expensed or fully depreciated the asset, while the other owes $1 million to the bank at 10% interest. Personally, I'd like to pay $1 million dollars less for company B than A. A simple EBITDA ratio, however, would value the firms equally, and this is ridiculous. If a third company, otherwise equal, has been paying off a liability claim from a discontinued product line, and the last payment was made in the current reporting period, it will show a lower EBITDA than its peers. Worse, suppose a fourth company is about to start payments on a structured settlement that will persist for 5 years... an EBITDA ratio won't reflect the situation. The bottom line here is that while any or all of these circumstances can be ignored as being "unusual"... there are always unusual circumstances, so the generic valuation guidelines always have issues of some sort - only the scope and significance change. Caution must be your watchword as you proceed.
There are a bunch of basic business principles that form the core knowledge base upon which top-tier MBA's are built. When you sit through the lectures and mathematics during your first year of B-school you tend to accept these as "truths we hold to be self-evident". You then spend the second year trying to learn how to violate each and every one of the fundamental tenets - ethically, of course! With advance apologies - many of those who have studied the same tenets in lesser forums, such as on their own or at weaker schools, tend to get them almost completely wrong. If you do not understand the mathematics of Beta calculations, you might want to take Mr. Lincoln's advice when the subject comes up. Similarly, words like "hedge", "efficient markets", "information transparency", etc., have specific meanings that are not quite what the words suggest. It is important that you understand the specific meanings of numbers and formulas when you are doing valuation or else you might as well just guess. I'm about to frustrate most of the people reading this because I am going to start by giving you even more warnings about flaws as I walk through the definitions and concepts. Think of this as your lecture in shop safety - before you use the power tools make sure you aren't about to cut off your arm.
Most valuation methods are, at their core, based on DCF analysis, or discounted cash flow. Even the basic rule of thumb techniques ultimately are simply shorthand mechanisms for predicting the amount of cash that can be had through executing the processes of the analyzed business. So here come the caveats - the general case versions have way too many flaws to be taken seriously. Most of the value in DCF calculations comes from the terminal state calculations on the far right of the pro forma spreadsheets, which inevitably predict that the business will survive and prosper forever. Doesn't happen. Besides the Catholic church, name a company that's been in continuous operation for over 400 years (there are a few). OK - 20 years is generally a sufficient surrogate for forever in the calculations, but the point is that you need to understand the assumptions in order to use the generic tools. Now it is time for a reality check: do you understand discounting (if you answered 10% off at Ross - duh!, then you do not), pro forma, revenue, and profit? If you answered yes to all you also fail - seriously, what does profit mean without more context? More apologies, but before you turn on these power tools you need caution and knowledge.
If I give you a dollar now, it is worth more than if I give you a dollar next year, assuming that banks are still paying interest for savings accounts. If I offer to trade today dollars for future dollars you should accept the deal with no limit, put the today dollars in the bank, then pay me back next year and keep the interest. So the value of next year dollars is less than today dollars, and to compute how much less, I basically divide them by the interest rate I can receive on today's dollars, which is called discounting. The longer the time period, the lower the value of the future money. There are a few extremely rare exceptions - times when deflation occurs, but honestly they are rare enough and dangerous enough that you need not worry too much. (If a 1200-mile diameter meteor is about to strike the earth, you can stop worrying about the long-term impact of pesticides on your liver.) A business is basically a cash pump - you buy it or build it at a certain cost, then it pumps out money until the assets all break or are used up. Most businesses continually reinvest over their lifetimes, which makes everything more complicated. When you invest in a business or an asset you are paying a pile of today dollars in exchange for a stream of future dollars, so you value both and decide which is worth more to you. Today dollars are tangible, future dollars are speculative, so there should be an element of risk calculation in your assessment.
"Pro forma" is easy - the dollars in your pocket represent reality. The projection of what will happen after you invest them is the "pro forma" version - i.e. the analysis of the expected consequences of an investment (or any businesss action). If I have $1000 in my pocket, my current projections are that I will still have it five years from now (risk adjusted for robbery etc., it's probably worth a bit less than $1000). My current plan is to put it in the bank, so my pro forma income statement would reflect the pittance my bank would give me. If I invest it in my cousin's latest get-rich-quick scheme I will receive $300 per year for the next 4 years, then get back $1300, for a total of around $2580 (not an error - why?) future dollars, however ... (HUGE CAVEAT) ... there is only around 10% chance that this will actually happen, only a 50% chance that I will receive even the first payment, etc... so the risk adjusted future value would be around $320, which explains why I rarely invest in my cousin. If I put the money in my 401K I can expect on average to get the market return of 9%, but I have my doubts about the historical rate meaning much given the recent changes to the way that the financial markets function and are structured, so I would risk adjust that down to around 5%. In business plans you are presented with a pro forma view of the business, but like most people, you probably do not have a pro forma understanding of what happens if you do not invest, and you are even less likely to have a risk-adjusted pro forma view of both scenarios. So like everyone else, you compare tangible present dollars to intangible "wishfull thinking" dollars, neither of which reflects the truth about coming attractions.
Now on to profit... there are many different types of profit, and the one I care about is economic profit. Here are the differences: gross profit is the difference between the sales price and the cost of production of an item. If I buy a banana from Trader Joe for 19 cents and sell it for 30 cents I have a gross profit of 21 cents. If I spent 2 cents on gas, 2 cents on a telephone call to arrange the meeting, and paid myself 4 cents for labor (cost of sales not production) my profit before taxes, interest and depreciation (EBITDA) might be 13 cents. After taxes, depreciation on my car, interest on the car loan, etc., my net profit might be 3 cents. This would be pretty darned good compared to the real world - 44% Sales/EBITDA ratio, 10% Sales/Net ratio - If I compare this to an investment in Superfoods, I'd be an investor ... however ... I'm not a licensed banana seller, and I don't have a food server permit, and I left out a bunch of other stuff, so actually I am a high-risk business since I'm likely to be closed down fairly soon. Therefore, I'm entitled to more profit than a more compliant competitor. Further, it won't be long before another entrant sells bananas for a penny less, until such time as the profit stops being worth the risks - in other words competitors will drive the price down to the proper price whereat I am indifferent between the risk adjusted rewards of this business, and the risk adjusted rewards of the Superfoods business. Since the market will also drive the price of Superfoods down to the level where I am indifferent between it and an investment in CountyBank (for example), or any other company, then the excess profits will eventually be gone - i.e. unless I can constrain the market in some way, my profits are completely offset by the risks. Economic profit is the difference between the net profits and the average risk adjusted profits of a company in this industry. I want that. That means that all things considered and properly analyzed I am outperforming my alternatives. Woohoo. That kind of profit usually comes via monopoly, regulative constraint, uneven playing fields, massive size, or any of the other competitive levers you read about. It doesn't come from selling TJ bananas on the street, except maybe at midnight when TJs is closed and the regulators are asleep... and even then risk is usually correctly priced into the equation.
So let's put these ideas together - I'm thinking about buying a stable, non-growing company for $1 million which has an EBITDA of $100,000/year. I can get 4% interest from my bank, or 9% interest on average if I invest in the stock market and believe in fairies, so is it worth looking at? Corporate tax (which is different from and additive to individual income tax) is going to run around $40,000/year, so my net would be a maximum of $60,000 before accounting for risk, which puts it between the risk-free rate from the bank, and the average market rate. Since any company is intrinsically more risky than all companies collectively the market investment is preferable, so I'll pass. Get that EBITDA up to around $150,000/year and I start becoming interested - again with the caveat of the laundry list of cautions to check for. It still sucks because of the risk vectors, but it's at least becoming reasonable... i.e. I make as much as I would investing in the market as a whole. Therefore, I'm beginning to take notice of stable companies when their P/E ratio is 6.5:1 or less. If the company and/or market is declining, I need lower, and if the company and the market are growing (more or less in sync) I can tolerate a little more. How do I figure out if the market is growing and expected to keep growing? Look at the P/E for the industry as a whole - most of the time (another giant caveat) the junior, just-got-out-of-business-school analysts who compute and publish such things get the basic ratios right. In general, the bigger a company is, the less risky it's survival is, so in the case I described, I'd assess a pretty big risk factor, since a $1 million dollar company is basically an insignificant rounding error in comparison to most industries. So where do most companies sell? In or around 5:1, if the EBITDA is dependable, there are no strategic defenders of growth rates, and there are no giant gotcha's to worry about. If the company is offered at a P/E of 4:1 or less I would be darn sure to do my dilligence carefully - the incumbents know more about their company than you do, and if they are discounting it, figure out why.
Sounds easy right? Too bad it doesn't work that way. Small companies can pay their owners salary, or via dividends, or (not proper but regularly done) by paying the owner's expenses as business expenses, or in some cases, not pay the owners at all. EBITDA just doesn't translate as well as it should so we need alternate guidelines even on a high-level basis. Price to sales is another easy to compute ratio, so let's take a look at it.
Most small stable companies are valued at between one to two times their annual sales. Why? Because on average EBITDA is around 10-20% of sales, so net cashflow (assuming no debt) is around 6-12% of sales, so the company starts looking more interesting than the market as a whole at a 1.0 ratio when the margin is at the high end of that range, and at 2.0 when at the low end. Assuming a company is an average performer in its industry, it can expect an average margin, and the industry's price/sales ratio gives a good cross check for value. If I'm getting a lower ratio than the industry average, and everything looks kosher, woohoo. Again, a growing company in a growing market is entitled to a higher ratio since future cash flows should increase, and conversely, contracting companies or industries warrant (huge) discounts, or lower ratios.
What's wrong with this picture? Suppose I know I'm about to sell the company - it's time to offer discounts to all my customers to entice them to place advance orders. It'll screw my future earnings ratio, but it'll pump my current sales. If I'm smart, and not terribly ethical, I decrease my draw at the same time. This keeps my margins the same as historical averages, increase my sales, and suggests that I'm growing - all three of which look nice on the basic ratios, but it's not a sustainable situation. When I outline this in the context of a small business preparing to sell itself you might whisper "for shame" under your voice and perhaps even shake your head slightly when looking at me. Take a look at the books of banks that fail, or huge companies that suddenly file for Chapter 11 and you will see all sorts of creative techniques for painting rosy pictures in the hope that things will change for the better before anyone takes serious notice. So the caveat reads something like this: start with P/E, validate the basic calculation by taking a look at Price/Sales, then if you are still interested, go deep into the discretionary numbers to make sure they weren't rigged in a gross manner. Assuming you're still interested, throw it all away and do a real valuation since by now you should be willing to sign an NDA and get serious with the source data of the target company.
If you made it to here, you deserve a special treat, and that's what the price/employee ratio is. I care a lot about the sales/employee ratio in companies. It tells you a little about efficiency, and a lot about strategic positioning. Companies that are low-price competitors have extremely high ratios of sales to employees, whereas high-brow firms tend towards the other extreme. I expect gross margins (not EBITDA or net margins) to go in the opposite directions - order takers generate smaller margins than salesmen, but they move more product. At a minimum, this ratio can be used to cross-check the other ratios - if the company strategy is skewed one way or another from the general industry then the ratio should reflect this, and the ratio of EBITDA to gross margin should also reflect this (high-touch sales are more expensive than order taking). However, this ratio also indicates growth and performance potential of the firm - high efficiency firms are not likely to gain improved margins, but low efficiency firms with decent margins have a strong upside. Couple this to the price function, and you get a good assessment of the assets you are buying - if you are paying a lot per person, but the people are commodities in terms of function, then the price is too high. Conversely, inexpensive quality employees are a wonderful asset to discover. This ratio is not generic across industries, so there are no basic rules of thumb, but it is an easy to compute ratio that has a lot of potential to improve your understanding of the firm value, so do it.
In the next post we will dig into cash flow, which will provide support and insight into the guts of the firms and make the course estimates more meaningful.
Wednesday, March 16, 2011
Valuation - the essential business tool
A small company in New Jersey recently received a patent for an interesting variation of a commonly used chemical additive. Within days they had received numerous phone calls seeking everything from field-of-use licenses to outright ownership of the underlying patent. When an inquiry came in with a price significantly larger than their to-date investment, they basically put their business and lives on hold and tried to decide how to sell the company or product line. Since they had spent virtually all of their available capital developing the patent in the first place, this boon/potential exit point was a godsend, and for the most part the conversation focused on what part to sell and whether an additional 10-20% could be gotten out of the transaction, not really whether to sell, nor anything resembling true analytics.
Tell the preceding story to any small-firm CEO who has been struggling to survive for a couple of years and they nod knowingly, and under their breath whisper a small prayer wondering why such boons don't happen to them. Tell the same story to a top manager at a high-performing firm, or a heavy-hitting consultant from one of the major strategy firms and the response is more likely to be ridicule than respect. The jokes could go either direction - selling a twenty-dollar bill for $10, or paying $50 for the same bill. Nine out of ten times an IP seller is giving up gold in exchange for lead, but rarely do they understand why, nor what to do about it.
Our second basic example goes the other way - a large, profitable firm evaluated a business proposal that started as a fairly naive idea from a promising MBA hire that was massaged thoroughly by an expensive evaluation team led by an expensive group of consultants, and the standard complement of miscellaneous managers from finance, sales and operations, none of whom were particularly senior. The nominal sponsor was a senior VP... who attended perhaps four meetings and contributed an additional 6 hours reading, reviewing and nodding knowingly over the course of the evaluation project. A very impressive spreadsheet was developed to determine the IRR of the project - actually, a very impressive spreadsheet from a prior engagement was modified to determine the IRR, and after a few revisions it finally demonstrated the appropriate savings and returns to make the project appear justified. The IRR from the spreadsheet exceeded the WACC, not to mention the current treasury funds hurdle rate, the net investment proposed was fairly modest, so the project was assigned a high priority, launched, and after exceeding budget, both time and money, was completed a couple years later...promotions to be had by all sort of thing. However, despite the resounding success, a small boy with an inquisitive mind might have asked about the bottom line of the company - how come the unit was less profitable after deployment than before? What's wrong with this picture?
In both of our examples, the fundamental problem was something covered in the first semester of business school - valuation, or more specifically, failure to perform a proper valuation. In this series, we will cover the essential components of the valuation process, and show how effective enterprise valuation can and should be used as fundamental tool in the business decision process. We will review the basic "back of the envelope" strategies to support course decision making, and look into the deeper analysis necessary to make more precise choices, including risk analysis, probabilistic outcome assessment, etc. It is unlikely that you will be ready to hang out a shingle as a valuation consultant after reading these posts, but at least you will have a better set of questions and an understanding of how these types of decisions and choices should flow to the enterprise value, and interpret proposals in light of this understanding.
So to conclude this introduction, let's revisit our examples:
Our chemical additive inventor should have done a course valuation of the end-user industry to determine the potential value created by the invention. In this particular case, the potential value was roughly 1-3% of the total consumption of the substances to which the chemicals were added, which implied a potential gross value in excess of $1billion per year for one particular field of use (the industry served by the potential buyer). Customers will not change processes and formulations unless they participate in the value pool, and achieving a 40% penetration, regardless of technological superiority is generally an upper bound, so a gross market share of $200 million was probably the upper bound, and $100 million a realistic goal for a well capitalized entrant. Allowing for manufacturing, distribution, sales, and related costs, the expected EBITDA would have been between $10 - 20 million per year, suggesting an enterprise value of $50-100 million, significantly (i.e. an order of magnitude) above the purchase offer for the company... and this was not the dominant field of use. However, for an undercapitalized entrant the probability of generating a profit was slim, so the lower bound of profit opportunity would have been zero, but was now the offer price divided by the field of use ratio. Since this was a competitive industry with multiple well-capitalized incumbents, and this invention was a substantial and meaningful advancement of the current performance level, the bottom line was that the offer wasn't particularly good - so the right answer was either pass, or narrow the deal as far as possible to generate capital for development of alternate fields of use.
In our second example, the problems were fairly common: First, projects are almost always considered in terms of their local scope and impact, as opposed to their enterprise impact. Few organizations actually understand their critical paths as enterprises, so they often don't notice or don't properly assess the enterprise impact of projects that seem to be locally scoped. Second, teams working on project evaluations might as well be wearing blinders in regards to the organization as a whole - executive sponsors who do not have time to get their hands dirty should automatically delay or kill such projects until such time as they are of sufficient priority to warrant proper attention. In the first case, activity-based costing would have revealed that this project would result in an increase in demand of a resource that was already a constraining resource. This resulted in decreased response time for a fundamental departmental function that impacted several product lines. This wasn't a cost problem, it was a constraint problem. As a consequence, there were delays in unrelated activities, and therefore more management attention diverted to handling the rise in problems, which in turn decreased efficiency of the organization as a whole. This example was complicated, but it is analagous to installing new computer equipment, which puts a strain on the help desk and the support staff. Since a lot of staff have to be trained, there is a period of inefficiency for a few weeks. This causes problems everywhere else as well, so the knee-jerk prioritization response includes more meetings, more reports, etc., all of which tend to be permanent, and tend to decrease efficiency and performance. Also, adding knowledge requirements to staff tends to make them less efficient across the board, so their basic response times increase, again warranting more problem resolution and more attention, further constraining an already stressed resource.
Weak sponsorship is a fundamental flaw. Most senior executives who see poor initial return calculations will be extremely wary of subsequent revisions. When you change assumptions to make the numbers work you need a serious reality check before continuing. Younger staff tend to define evaluation project success as proceeding to implementation, rather than making the appropriate enterprise decision. In our example, the initial assumptions were conservative, the revisions were not... they weren't exactly in the "wishful thinking" category, but they were, at a minimum, optimistic. We generally encourage our clients to treat optimism as equivalent to magic - it's nice when it comes, but don't count on it. Therefore, the busy sponsor only saw the revised assumptions, accepted the footnoted vetting by the consultants that assumptions were provided by incumbent staff, and never once questioned whether the underlying model, which was developed for a different client in a different industry, was really an appropriate tool for this particular project, particularly since different companies have different critical resources, and different cost structures... not just different costs. This result is a subtle version of the Business 101 agency problem. Consultants make money from follow-on engagements. Junior staff gain significance via participation in executed projects, not through properly killing proposals. Neither junior staff nor consultants are directly incented for aggregate unit performance. The sponsor could and should have cared - he had actual skin in the game - but the project was fairly small and was never suspected as having the potential to powerfully impact overall business unit performance.
So now that we've talked a bit about what can go wrong, let's start at the beginning and look at the essence of valuation, and how to turn the process into a tool that assures that things go right.
Tell the preceding story to any small-firm CEO who has been struggling to survive for a couple of years and they nod knowingly, and under their breath whisper a small prayer wondering why such boons don't happen to them. Tell the same story to a top manager at a high-performing firm, or a heavy-hitting consultant from one of the major strategy firms and the response is more likely to be ridicule than respect. The jokes could go either direction - selling a twenty-dollar bill for $10, or paying $50 for the same bill. Nine out of ten times an IP seller is giving up gold in exchange for lead, but rarely do they understand why, nor what to do about it.
Our second basic example goes the other way - a large, profitable firm evaluated a business proposal that started as a fairly naive idea from a promising MBA hire that was massaged thoroughly by an expensive evaluation team led by an expensive group of consultants, and the standard complement of miscellaneous managers from finance, sales and operations, none of whom were particularly senior. The nominal sponsor was a senior VP... who attended perhaps four meetings and contributed an additional 6 hours reading, reviewing and nodding knowingly over the course of the evaluation project. A very impressive spreadsheet was developed to determine the IRR of the project - actually, a very impressive spreadsheet from a prior engagement was modified to determine the IRR, and after a few revisions it finally demonstrated the appropriate savings and returns to make the project appear justified. The IRR from the spreadsheet exceeded the WACC, not to mention the current treasury funds hurdle rate, the net investment proposed was fairly modest, so the project was assigned a high priority, launched, and after exceeding budget, both time and money, was completed a couple years later...promotions to be had by all sort of thing. However, despite the resounding success, a small boy with an inquisitive mind might have asked about the bottom line of the company - how come the unit was less profitable after deployment than before? What's wrong with this picture?
In both of our examples, the fundamental problem was something covered in the first semester of business school - valuation, or more specifically, failure to perform a proper valuation. In this series, we will cover the essential components of the valuation process, and show how effective enterprise valuation can and should be used as fundamental tool in the business decision process. We will review the basic "back of the envelope" strategies to support course decision making, and look into the deeper analysis necessary to make more precise choices, including risk analysis, probabilistic outcome assessment, etc. It is unlikely that you will be ready to hang out a shingle as a valuation consultant after reading these posts, but at least you will have a better set of questions and an understanding of how these types of decisions and choices should flow to the enterprise value, and interpret proposals in light of this understanding.
So to conclude this introduction, let's revisit our examples:
Our chemical additive inventor should have done a course valuation of the end-user industry to determine the potential value created by the invention. In this particular case, the potential value was roughly 1-3% of the total consumption of the substances to which the chemicals were added, which implied a potential gross value in excess of $1billion per year for one particular field of use (the industry served by the potential buyer). Customers will not change processes and formulations unless they participate in the value pool, and achieving a 40% penetration, regardless of technological superiority is generally an upper bound, so a gross market share of $200 million was probably the upper bound, and $100 million a realistic goal for a well capitalized entrant. Allowing for manufacturing, distribution, sales, and related costs, the expected EBITDA would have been between $10 - 20 million per year, suggesting an enterprise value of $50-100 million, significantly (i.e. an order of magnitude) above the purchase offer for the company... and this was not the dominant field of use. However, for an undercapitalized entrant the probability of generating a profit was slim, so the lower bound of profit opportunity would have been zero, but was now the offer price divided by the field of use ratio. Since this was a competitive industry with multiple well-capitalized incumbents, and this invention was a substantial and meaningful advancement of the current performance level, the bottom line was that the offer wasn't particularly good - so the right answer was either pass, or narrow the deal as far as possible to generate capital for development of alternate fields of use.
In our second example, the problems were fairly common: First, projects are almost always considered in terms of their local scope and impact, as opposed to their enterprise impact. Few organizations actually understand their critical paths as enterprises, so they often don't notice or don't properly assess the enterprise impact of projects that seem to be locally scoped. Second, teams working on project evaluations might as well be wearing blinders in regards to the organization as a whole - executive sponsors who do not have time to get their hands dirty should automatically delay or kill such projects until such time as they are of sufficient priority to warrant proper attention. In the first case, activity-based costing would have revealed that this project would result in an increase in demand of a resource that was already a constraining resource. This resulted in decreased response time for a fundamental departmental function that impacted several product lines. This wasn't a cost problem, it was a constraint problem. As a consequence, there were delays in unrelated activities, and therefore more management attention diverted to handling the rise in problems, which in turn decreased efficiency of the organization as a whole. This example was complicated, but it is analagous to installing new computer equipment, which puts a strain on the help desk and the support staff. Since a lot of staff have to be trained, there is a period of inefficiency for a few weeks. This causes problems everywhere else as well, so the knee-jerk prioritization response includes more meetings, more reports, etc., all of which tend to be permanent, and tend to decrease efficiency and performance. Also, adding knowledge requirements to staff tends to make them less efficient across the board, so their basic response times increase, again warranting more problem resolution and more attention, further constraining an already stressed resource.
Weak sponsorship is a fundamental flaw. Most senior executives who see poor initial return calculations will be extremely wary of subsequent revisions. When you change assumptions to make the numbers work you need a serious reality check before continuing. Younger staff tend to define evaluation project success as proceeding to implementation, rather than making the appropriate enterprise decision. In our example, the initial assumptions were conservative, the revisions were not... they weren't exactly in the "wishful thinking" category, but they were, at a minimum, optimistic. We generally encourage our clients to treat optimism as equivalent to magic - it's nice when it comes, but don't count on it. Therefore, the busy sponsor only saw the revised assumptions, accepted the footnoted vetting by the consultants that assumptions were provided by incumbent staff, and never once questioned whether the underlying model, which was developed for a different client in a different industry, was really an appropriate tool for this particular project, particularly since different companies have different critical resources, and different cost structures... not just different costs. This result is a subtle version of the Business 101 agency problem. Consultants make money from follow-on engagements. Junior staff gain significance via participation in executed projects, not through properly killing proposals. Neither junior staff nor consultants are directly incented for aggregate unit performance. The sponsor could and should have cared - he had actual skin in the game - but the project was fairly small and was never suspected as having the potential to powerfully impact overall business unit performance.
So now that we've talked a bit about what can go wrong, let's start at the beginning and look at the essence of valuation, and how to turn the process into a tool that assures that things go right.
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