A pound is a pound is a pound, surely. Well, yes, says David Molian Visiting Fellow at Cranfield School of Management, if we’re talking about money earned today. But when it comes to money earned in the future, it’s a different story. All speculative pounds are definitely not created equal looks.
In my last article for Fresh Business Thinking I compared and contrasted two kinds of business model: one which was built mainly on long-term, repeatable, predictable revenue streams and a second, based on one-off, short-term projects where revenues are hard to forecast from one year to the next. From many years of working with entrepreneurs and their businesses my experience is that, when it comes to harvesting the business, the market will always place a higher value on the former type than the latter.
In this feature I want to explore this idea further, starting with the idea of quality of earnings. This is a term that mystifies many business owners. A pound is a pound is a pound, surely. Well, yes, if we’re talking about money earned today. But when it comes to money earned in the future, it’s a different story. All speculative pounds are definitely not created equal. The business valuation model that most owners are familiar with is the price-earnings one, which is straightforward enough: a company is valued by a measure of its profitability multiplied by a number, the “multiple”. Profitability can be determined in a number of different ways, the most common being earnings before or after tax, or before interest, tax, depreciation and amortisation [depreciation of intangible assets]. The formula adopted is subject to the approach taken by a corporate finance specialist and the prevailing practice in the relevant market sector. Usually an owner-managed business’s accounts are also subject to “normalisation”, adjustments that take account of how the owner takes out money to reduce their personal tax liabilities, which affects the calculation of profit.
The calculation of the multiple is typically more opaque and a matter of
judgement. A valuer will take account of the market sector in which the business trades, recent comparable deals in that sector which set a benchmark for future transactions, and the value of the business to prospective buyers, which includes the sustainability of the business post-acquisition. That is the point at which the term quality of earnings is likely to crop up.
To help with the process of demystification, let’s take the case of pensions. Today we basically have two types: the defined contribution kind, where you know what has been paid in, but have little certainty about what will eventually be paid out; and the fast-disappearing defined benefit kind, often linked to final salary, where the recipient knows what he or she is going to receive when the pension is taken. The one thing they have in common is that each will provide a future income stream, but there’s a huge divergence in terms of certainty about what that stream looks like. Any IFA will tell you that if you have a choice, go for defined benefit every time.
Quality of earnings is essentially a way of expressing the degree if not of certainty, at any rate of confidence, about future income streams. When thinking about the value of their businesses, entrepreneurs generally tend to focus on the profit, or better still, the cash generated. The perceived quality of earnings, however, has a direct impact on the calculation of the multiple: the more confidence a buyer has in future income streams, the more valuable the target business is likely to be.
The implications of this approach to valuing a business can cause some surprises. A business which is less profitable can actually be worth more in the market than one which is more profitable. How so? Well, take a business with a sustainable annual net profit of £0.75 mn, and contrast it with a peer company with a comparable figure of £1 mn. If the former is valued at a multiple of 10, that gives us an enterprise worth of £7.5 mn. If the latter is valued at a multiple of 5, that puts the business’s worth at £5 mn. Business A is worth 50% more. I’ve seen the look of horror on people’s faces when they’re given this kind of glad news. I’ve also seen the look of relief and pleasure on the faces of people who have been rebuffed by the market, worked hard to change the business model, and secured a higher price second time round.
Food for thought? Multiples, like business models, are not eternally fixed. In a space of no more than two years a business can change both, through systematic planning and action. But it requires commitment and an openness to fresh thinking.
David Molian is a Visiting Fellow at Cranfield School of Management and former Director of Cranfield’s renowned Business Growth Programme.
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