Investors determine company values based on a wide range of factors, from product differentiation to the outlook for sustainable and profitable growth. Business leaders should use their same criteria as a scorecard to maximize value creation within their company over time.
With that in mind, here’s a list of the core elements of value that companies should focus on optimizing:
- Large and growing market: A company with access to a large and growing market has several advantages: investors can see it has room to grow, there are many potential customers for its products and services, and if the market is growing, there’s often less competitive tension (i.e., different companies can capture different market segments and/or there is more green space available for all).
- Significant and growing market share: Companies have to demonstrate that they’ve differentiated their products from the competition. They don’t necessarily need to have huge market share – investors are particularly interested in whether they have significant market share relative to their competitors and whether or not their market share is growing or shrinking over time.
- History of growing revenue: A company with consistently high revenue growth shows investors that its products and services are valued by the market. PwC reports that companies regard sales growth as their most important metric for measuring innovation, a reminder that growing revenue is also an indicator of performance in other areas.
- Low customer churn: Investors need to know that your company has a strong value proposition relative to its competition, and a low customer churn rate is a key indicator. According to McKinsey, companies with “top-quartile growth have lower customer churn than mean performers – from about 10 to 30 percent lower depending on customer type.”
- Low customer concentration: If a company has a small number of customers who account for a significant amount of its revenue, losing even a modest proportion of those customers could set that company back years. An article published in the Journal of Marketing found that a 10 percent increase in customer concentration “reduces profitability by 3.35 percent (or about $7 million) in the subsequent year, or 9.4 percent cumulatively over the next four years (or about $20.32 million).” However, if a company has low customer concentration, it’s not as big of a deal if it loses customers here and there so long as other trends are healthy.
- High gross profit margins: Gross profit margins (GPM) indicate the price of a company’s products versus the costs to make and deliver them. To investors, GPM is a key indicator of a the differentiation of a company’s products. If a customer is willing to pay significantly more than a product costs to make, the product is generally scarcer and creates relatively high value for customers. If a company has a low GPM, the product is typically more commoditized and indicates the company is a market taker versus maker and/or is not cost conscious.
- High operating profits: GPM are important, but they are not everything. If a company can make products and services that generate substantial cash flows after it also pays for operating expenses like selling, general, administration, depreciation and other infrastructure costs, it demonstrates to investors that it’s capable of generating cash flow without a huge infrastructure or capital expenditure requirement. At the end of day cash generation is king when it comes to investors.
- Strong management team with low key-person risk: People are what ultimately matter in a business, and they drive all of the above. Investors want to see strong management teams with thoughtful people in each of the key executive spots. However, if one executive is irreplaceable, this can lead to systemic risks – for example, Morgan Stanley found that companies with key departures in 2017 underperformed the rest of the market by 11 percent in the preceding year. If you have weaknesses in your c-suite, do your best to coach up your existing team and/or supplement it with additional talent.
When companies are considering which elements of value they should emphasize, they should consider how potential investors would view their performance. This requires leadership teams to take a step back, objectively appraise their strengths and weaknesses, and ask tough questions. There are a variety of select third parties that can help you expertly address and improve each of the above. In fact, I’ve built an entire business focused on helping the world’s top private equity investors confidently use them every day to accelerate and de-risk the growth and development of their portfolio companies. These resources, used by PE funds, are also accessible to proactive business leaders.
By taking the perspective of outside investors, business leaders will identify more opportunities, reduce the risk profile of their company, and drive accelerated value creation over time.
Written by Sean Mooney. Have you read?