Intrinsic Value per Share and the Roadmap to Measurable Value Creation

In my previous article, Value is in the Eye of the Beholder, I presented the idea that the definition of value can vary depending on the stakeholder. I stated that for shareholders, value is ultimately measured in financial terms, and the best way to measure financial value is based on an increasing notional equity value per share.

The key is to understand that equity value – like an ESPN sportscaster – only tells you the result after the game has been played. Business owners, like the players in the game, need to know what must be done while the game is being played to impact its outcome. In this article we are going to learn about these drivers and how you can use them to influence the value of your company.

Equity Value per Share – "The Holy Grail"

Let's begin with the end result in mind – an increased notional equity value per share – and work backwards to the components that you can influence in your business on a daily basis.

Equity value per share is a metric that is derived from taking equity value (the numerator) and dividing it by the number of shares (the denominator). In private companies, the number of shares remains largely unchanged, so the focus of this roadmap is in increasing equity value or the numerator. Equity value has two components being enterprise value and the level of debt net of available cash, both of which can be managed by an experienced operator and financial manager to amplify equity value. Of course, this assumes the private company is salable, and there is a market value for the equity that is higher than its existing book value.

This article gives you the highlights on how to do this. If you want to skip these highlights, I have developed a comprehensive checklist that walks you through each component in detail. I developed it to help me manage our companies to drive an improved equity value per share.

Please contact me here if you wish to receive this checklist.

The Two Buckets – Performance and Multiple

Valuation drivers fall into two buckets – performance and multiple. These two buckets are like two matching domino pieces, interconnected with each one and highly dependent on each other.

The performance bucket is usually measured by the level of recurring and sustainable free cash flow (often used interchangeably with EBITDA, but I'll get to the difference later). Bottom line, the higher and more predictable the free cash flow, the better.

The question is: what steps do I take as a business owner to get to higher and more predictable FCF?

The multiple bucket is usually measured by how high of a multiple can be obtained for the company's free cash flow. This bucket is a little trickier to manage. The multiple is highly influenced by the type of industry the company is in, and it is often considered to be "market driven." This is to a certain extent true – a company in an industry that averages transactions with multiples in the range of 5 – 7x TTM EBITDA is likely to fall within that range. However, what can be managed is what makes the difference between landing at the low or high end of the range, and there is a huge valuation premium if you can influence one or two more turns on EBITDA.

The Rule of 7

Over the years, I've summarized all the value drivers that I work with into seven for each bucket. At a high level, the seven components of the performance bucket that drive free cash flow include:

1. Clean revenue – not all revenue is created equal, and some revenue can actually be "bad" if it ties up your resources and generates zero margin. The five pillars that drive clean revenue are pricing flexibility, utilization, predictability, recurrence, and sustainability. Valuable companies regularly cleanse their revenue by focusing on the highest margin and repeatable revenue sources.
2. Margin expandability and integrity – this one goes hand in hand with clean revenue. I really dislike companies with big revenue lines but contracting or unpredictable margins. So do most other buyers. In order to drive high free cash flow, a company owner needs to ensure margins expand and stay predictable which requires a deep understanding of the company's cost structure, appropriate cost classification, and cost certainty.
3. An optimized fixed overhead – this can be managed through improved asset productivity, the "variable-ization" of fixed costs, proper cost allocation, and outsourcing.
4. Capital expenditures discipline – this is particularly important for capital intensive companies. This means ensuring that every capital expenditures delivers a return that is higher than the company's cost of capital.
5. Working capital management – this means making sure the company turns its products or services into cash as quickly as possible rather than carrying high levels of working capital. The best situation is "negative working capital" where you are collecting cash in advance of incurring costs and other current liabilities, although you don't see this too often.
6. An optimized capital structure – this influences how much cash flow is consumed by the cost of carrying debt. I say "optimized" because the right amount debt can enhance returns as long as it doesn't hinder the operations. In some cases, a higher level of debt can be an option to selling your company.
7. Cash taxes minimization or deferral – this step is often forgotten or ignored. Company owners work extremely hard to drive pre-tax profit, only to see it erode when a proper tax plan is not in place.

The seven drivers of multiple within the multiple bucket that a company owner can influence include:

1. The quality of earnings – in essence, how close is earnings to real cash flow. The main culprits here are usually maintenance capex and a high level of working capital requirements. This either means you need to replace capital assets regularly to keep up, or your customers take way too long to pay. Stated in another way, the less capital reinvestment and/or working capital requirements that a company has, the higher the quality of earnings. In some industries, the "da" in EBITDA actually means a real cash outflow.
2. An actual management team and/or succession plan – this boils down to making sure you have a 2IC in place. Companies that are less dependent on the original owner are more valuable because this value can be transferred to a buyer. They usually command a higher multiple.
3. Size and scale – You can control the size of your company, and usually bigger companies command a higher multiple than smaller ones. This is because there is a certain level of effort that goes into buying and integrating a company, so a buyer wants to make sure the transaction is large enough to warrant the investment of time and resources. However, size for its own sake is detrimental. High revenues with low or contracting margins is not a positive sign; therefore a larger company will drive a higher multiple turn only if it holds its margins.
4. A well defined value proposition – Buyers look for companies that understand why clients pick their products over their competitors and what drives them to pay a premium price. Therefore, company owners should understand this and articulate it so that daily behaviors are aligned with what problem the product or services resolves for the customer better than the compeitition.
5. Process and standard operating procedures – this comes down to being able to transfer the value in the business. If there is no system, the business loses value because a buyer cannot manage it without the owner being around.
6. A "moat" or barriers to entry – this all boils down to creating barriers around your products that would make it difficult for competitors to get in your space. There are many steps to creating barriers to entry, but some of the ones company owners can control is obtaining patents, licensing rights, and accreditations for products and services.
7. Story – or "strategy" as it is sometimes called. I find that company owners who can tell the right story about their company, where it came from and where it's going, can generate a better valuation than those with a disjointed story.

The Convergence of the Two Buckets

Whew, that was quite a few points. Thanks for making it this far. The point of this article is to 1) introduce these drivers, and 2) further emphasize the point that it's not just about cash flow, and it's not just about multiple. If you optimize one without the other, you are leaving money on the table. When an entrepreneur understands these drivers and can communicate them in a sales process, the results can be amazing.

Stay tuned for future articles on these drivers, but in the meantime, please give me a shout if you want to get my checklist.