V = Expected Cash Flow / (Discount Rate – Expected Growth)
Implicit in this equation are two assumptions. First, all expected cash flows are distributed to shareholders (or, in the alternative, reinvested in the business at the discount rate). Second, the expected growth rate for the cash flows in a constant growth rate. The discount rate is often called r, and the expected growth rate is called g. For simplicity, we will call expected cash flow CF. So the equation, which can be referred to as the basic valuation equation, becomes:
V = CF / (r – g)
This equation can be further simplified into one that is easily understandable. Cash Flow in this equation is “capitalized” by dividing by (r – g). 1 / (r – g) is equal to a multiple. For example, if r equals 15% and g equals 5%, 1 / (15% – 5%) = 10, so the multiple under that assumption would be 10x the measure of Cash Flow being considered. Simplifying, we see that:
V = CF x M
For a given level of earnings (CF), a higher multiple yields a higher value. Simple, yes, but we now know that the multiple is a function of expected risk and expected growth. Simplistically, then, value is a function of expected cash flow, risk and growth.
Acquirers will be asking questions like: “What are the realistic expectations for earnings (cash flow)?” and “What are the realistic expectations for future growth of earnings?” and “What is the realistic riskiness of projected earnings?”
One way or another, discussions of value always get back to expected cash flow, expected growth, and risk.
Let’s look at “Commanding Top Dollar” through the lens of the basic valuation equation. Spiraling Up was written based on original research by Hinge Marketing. Four studies were conducted over a three year period. Interviews were conducted with several hundred CEOs and other high-level executives. Interviewees included leaders of professional services firms, buyers of such firms, and valuation experts. What did they have to say about “Commanding Top Dollar”?
According to the research summarized in Spiraling Up, five top value drivers emerged:
- Quality of the Management Team
- Quality of Earnings
- Existing Client Contracts
- Projected Growth Rate
- Strength of Existing Client Relationships
The order was reversed in the chapter, but the above is a good outline for our discussion. What do each of these value drivers have to do with value, i.e., with expected cash flow, growth and risk?
Quality of Management Team. Management is a key to the success of virtually every business. This value driver was mentioned last in Spiraling Up. My guess is that the managers, acquisition people and valuation experts interviewed simply take good management for granted when they consider acquisition prospects.
No one can take management for granted, but when we are talking about paying top dollar for a professional services firm, the candidates will generally have good quality management.
From the viewpoint of the basic valuation equation, management is the glue that keeps your business machine running and well-tuned. Management focuses on cash flow, attempts to reduce risks (or take reasonable risks), and seeks growth opportunities for earnings.
Quality of Earnings. The discussion in Spiraling Up indicated that this value driver related to high quality financial statements without mirrors. In other words, buyers want good quality financial statements.
Short-term enhancements to the bottom line are often transparent. Buyers will not capitalize “smoke and mirrors” on your financial statements. Rest assured, knowledgeable acquirers will focus on the quality of your financial statements.
If you have only internal financial statements, a review, or even an audit could be required at the time of an acquisition. Failing that, buyers will protect themselves to assure that the cash flow they are buying is actually there. Remember that it is your CF, or cash flow, or earnings that the buyer is interested in acquiring.
Existing Client Contracts. Acquirers are interested in the repeatability of earnings. Consider two professional service firms in the same field, both of which have revenues of $5.0 million.
The first firm had 100 clients last year, and 80 of them were new to the firm. The second firm also had 100 clients, but 80 of them were repeat clients and only 20 were new.
The latter firm will be generally more attractive to buyers than the first. It is easier to maintain existing relationships than to develop new ones. It is easier to grow with 80% client retention than with 20% retention.
Now consider a third firm of similar size that has 50 clients, and 40 of them are under multi-year contracts. This firm might be even more attractive to aquirers, depending on the margin concessions that may have been necessary to achieve those contracts. However, this business model simply is not available in many professional fields.
Projected Growth Rate. Buyers are all too familiar with what have been called “hockey-stick projections.” Regardless of the recent past record of growth or lack thereof, the future is always bright.
It is common sense that, other things being equal, higher expected growth will yield higher value. If the growth is believable, buyers will pay more because they expect there to be more dollars of earnings in the future to work with.
Assume two companies are earning $500 thousand each. The first is expected to grow at 5%, so projected earnings five years out are $638 thousand. The second company is expected to grow at 15%, so its earnings are expected to double, or to be $1.0 million in five years. Buyers will pay more for the second company, and sellers will demand more. The latter company is simply more attractive than the first.
Recall that g (growth) is in the denominator of the basic valuation equation. In the example above, with a discount rate of 15% and a growth rate of 5%, the implied multiple of earnings was 10x. If the expected growth rate is 8%, the implied multiple [1 / (15% - 8%)] is 14.3x. Growth matters.
Strength of Existing Client Relationships. This fifth value driver in Spiraling Up was actually the number one driver in the study. It is the strength of client relationships that make high quality, high margin earnings possible.
A professional services firm with strong client relationships, i.e., with clients who like and enjoy doing business with it is attractive. If the firm solves the client problems with minimum effort or distraction, clients are even more “sticky” and the base for future growth is well-established.
A number of years ago, I developed a series of charts around “the Core” of a business. The Core is comprised of current products and services and current customers. The length and quality of client relationships are aspects of maintaining a good Core for your business. All products and services eventually become obsolete.
The Core is always under attack from client attrition. I have learned a thing or two over the years about client relationships: every relationship has a beginning, a duration, and an end. It may not be a good word, but clients “attrite.”
The Core is also always under attack from product or service obsolescence. The better the services (or products) of a professional services firm solve clients’ problems, the stickier the clients will be. Visually, we can think of the Core as a diminishing asset over time.
The fact that the Core of your business is diminishing is inescapable. One of the key messages of Spiraling Up, although it is not stated in just this way, is that the stronger the Core of your professional services business, the easier it will be to grow and the more valuable it will become.
The second chart gives a visual picture of the inevitable shrinking of your Core over time. Good managements understand this and work on branding and building sticky client relationships. They also introduce new products and services when necessary or appropriate to solve their clients’ problems, again, with minimum effort or concern for them.
If the Core is continually shrinking, how does a professional services firm grow? What we learn is that new customers have to be gained and new products and services have to be developed. It is the relationship between the attrition of the Core and the growth of new business that determines the ability of a professional services firm to grow.
If client retention is 80% as in the example above, then a company can maintain its business level by attracting 20 new (average) clients. If 40 new clients are developed, the business can grow 20% in a year. In the alternative, if client retention is only 20%, the business must attract 80 new clients just to stand still. Growth is exceedingly difficult and expensive in such situations.
As is clear from Spiraling Up, a firm needs a strong “brand” within its client (and referral source) base. The number one value driver found in the research for the book was “strength of existing client relationships.” When we look at the basic valuation equation above, we see that value is a function of expected cash flow, expected growth, and the risk associated with the cash flows. Frederiksen and Taylor said it well;
When it comes to commanding a premium valuation, nothing is more important than the strength of your client relationships. By “client relationship,” we aren’t talking about how often you golf or vacation together. While these activities may drive some sales, personal relationships can’t be transferred to a new owner, nor are they scalable. Consequently they add very little real value to your firm. In fact, the most valuable client relationships are based on ongoing business relationships between firms. They have very little to do with personal chemistry. Instead, they are relationships that provide proven value to clients — value that both sides acknowledge and can be documented. Put another way, a firm should have a strong “brand” within their clients’ worlds.”
The conceptual wisdom of these observations is affirmed by looking at the Core of your firm and its inevitable shrinking over time through client and product attrition. Slow down the shrinking of the Core by focusing on client relationships. Solve client problems, both existing and emerging, and slow attrition. Add new clients and provide the same service so that they are sticky with your firm. Do these things and growth is easier, more fun and will create more value. Spiraling Up is available for complimentary download right here.