How can understanding the art and science of business valuation empower you to make informed decisions about starting a business or investing in one?
Valuing a business is not just an academic exercise but a critical determinant of whether a business idea or existing operation can thrive in the long term. This question has intrigued me for years, particularly during my classes with Professor Ashwath Damodaran, whose insights into valuation frameworks have shaped much of my thinking.
Beyond the frameworks, I often reflect on broader questions: Should one start a business or work for a company? If starting a business, what would justify the effort? And how do concepts like business models and operating models translate into real financial viability?
This article delves into the nuances of valuing a business, exploring why some businesses struggle to generate shareholder value and what metrics truly matter.
1. The Foundation of Valuation
At its core, valuing a business revolves around determining its ability to generate returns that exceed the cost of capital. A viable business must not only sustain itself but also grow its value over time. Two key pillars underpin this:
● The Business Model: How does the business make money?
● The Operating Model: How does it execute its vision to achieve profitability?
Both models must work harmoniously to ensure that the enterprise value exceeds the cost of capital, creating wealth for stakeholders.
2. The Importance of Free Cash Flow Per Share
Many analysts focus on ROI or ROIC, but I argue that free cash flow (FCF) per share is the most critical metric. FCF represents the cash left after a business has met its capital expenditure and operational costs. It’s the true measure of financial health, as it reflects the surplus available for reinvestment, debt repayment, or shareholder returns.
Unlike accounting profits, FCF is harder to manipulate and provides a clearer picture of a company’s ability to sustain operations and grow. By tracking it on a per-share basis, stakeholders can assess whether a business is truly creating value.
3. Capital Investments: A Double-Edged Sword
One of the most significant drains on cash is capital investment—purchases of long-term assets like machinery, technology, or facilities. While such investments are essential for scaling, they can backfire if not aligned with the business’s ability to generate returns above the cost of capital.
For example, if a company invests $100,000 in machinery, that asset must generate sufficient free cash flow to cover not only the investment but also the cost of capital for financing it. If not, the investment becomes a liability over time.
This is where the advantage of scale comes into play. Large firms often have lower costs of capital due to stronger creditworthiness and established market positions. Small firms, on the other hand, face higher borrowing costs, making capital-intensive projects riskier and reducing their ability to generate shareholder value.
4. Managing Working Capital Effectively
Effective working capital management is another crucial factor in valuing a business. Companies like Amazon and other digital-first firms excel at this by:
● Optimizing Inventory: Amazon’s just-in-time shipping model minimizes inventory costs. Similarly, businesses like Airbnb and Netflix operate with little to no inventory, drastically reducing overhead.
● Improving Payment Terms: Scaling businesses often have greater negotiating power, enabling them to secure favorable terms with suppliers (e.g., paying suppliers after collecting payments from customers). This improves cash flow and reduces the need for external financing.
● Leveraging Technology: Digital businesses benefit from economies of scale. For instance, the cost of developing software or digital platforms does not increase linearly with customer growth. This means that as the user base grows, the fixed cost per unit decreases, enhancing profitability.
5. Scale and Shareholder Returns
The interplay between scale and shareholder returns is vital. Large businesses typically enjoy several advantages over smaller firms:
● Economies of Scale: Fixed costs, such as technology investments, can be spread across a larger revenue base.
● Lower Cost of Capital: Established firms can access capital at lower rates, making investments more financially viable.
● Operational Efficiency: With larger operations, businesses can negotiate better supplier terms, optimize logistics, and reduce per-unit costs.
This dynamic explains why larger companies often deliver better shareholder returns than smaller, capital-constrained competitors.
6. Why Some Businesses Struggle
Despite these principles, many businesses—gyms, restaurants, and product companies—struggle to create value. Let us examine Why?
Gyms
● High fixed costs (real estate, equipment) and low margins.
● Underutilized memberships leading to churn.
● Lack of diversified revenue streams (e.g., online fitness classes or premium training services).
Restaurants
● Thin profit margins due to high food and labor costs.
● Low scalability compared to digital businesses.
● Demand variability and seasonality impacting revenue predictability.
Product Companies
● Premature scaling before achieving product-market fit.
● Unsustainable cash burn without generating consistent free cash flow.
● Misaligned pricing strategies that erode margins.
7. Lessons in Business Viability
Ultimately, businesses succeed when they align their models to generate sustained free cash flow while managing costs and capital investments. My call to action to CXOs would include:
Focus on Unit Economics: Ensure every transaction or customer adds to profitability.
Think Long-Term: Prioritize strategies that create sustainable cash flows, not just short-term revenue.
Optimize Scale: Leverage economies of scale to reduce costs and improve profitability.
Rationalize Capital Investments: Ensure that every dollar invested generates returns exceeding the cost of capital.
Master Working Capital: Use strategies like just-in-time inventory and favorable payment terms to improve cash flow.
Final Thoughts: Free Cash Flow as the True North
In valuing a business, metrics like ROI and revenue growth are important but insufficient. The ultimate measure of success is the business’s ability to generate sustainable free cash flow per share. By focusing on this metric and managing capital investments and working capital effectively, businesses can achieve long-term viability and create lasting value for stakeholders.
The question remains: How do you evaluate the viability of a business? Is it an Art or a Science? I would argue it is both, but I hope the perspectives presented in this article will help you value a business more accurately. Share your thoughts—I’d love to hear your perspective.
For further discussion on the same, please reach out to Mr. Krishnan CA on LinkedIn.
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