So how can business value deteriorate in spite of earnings growth? The simple answer, is that the incremental earnings were not enough to cover all the operating costs plus the cost of capital (including the opportunity cost of the equity in the business). Every business owner/manager needs to know precisely their weighted average cost of capital or WACC, in order to manage it judiciously. Simply growing your operating profit without considering the full cost of both the fixed and working capital will not necessarily build value into your business and is only part of the story.
Some examples of value enhancing management strategies are given below.
1. Increase profits without tying up any more capital. This can be in the form of improving margins and/or lowering operating costs or both, as long as the capital does not increase.
2. Decrease capital without losing earnings. Some possible options include:
- Lowering inventory levels (or increasing inventory turns)
- Shortening selling terms or improving collection practices
- Negotiate better supplier terms or take better advantage of supplier incentives
- Divest redundant assets
3. Divest, liquidate, or discontinue parts of the business, where the lost earnings are more than offset by the savings in the cost of capital.
4. Only invest (increase capital) in projects that provide a return that exceeds the cost of capital.
5. Reorganize the capital structure of the business to lower the overall cost of capital.
While topline and profit growth are essential elements of increasing enterprise value, profit growth needs to be disciplined and it must always exceed the cost of capital.
The astute reader may realize that I am referring to concepts espoused by practitioners of “Economic Value Add” or “EVA“ – a profit metric that is netted against a charge for the WACC. A business that focuses on increasing EVA over the long-term, becomes meticulous at managing the capital entrusted to it by its shareholders.
Other astute readers may be thinking that it is the market that ultimately determines the value of any business. For private businesses, that typically means it can only be determined when the business takes in new investors, or when it is put on the market to be sold. Of course there are many factors which determine the value of any business. However, disciplined profit growth is typically rewarded by attracting more buyers or investors that are willing to pay higher multiples of earnings.
In summary, generating profit growth without considering whether it exceeds the full cost of capital is like driving a car blindfolded – you may be moving but could easily be heading in the wrong direction.
Bosveld and Associates helps our business clients address real problems with practical solutions in a cost-effective manner. Our mission is to assist our clients in building and incorporating business management systems and practices that drive profit, accelerate growth, reduce risk and increase enterprise value. To achieve our mission, we combine our real world operating experience with a unique blend of innovative technology and alliance partnerships with deep subject matter expertise.