Business valuation experts can play a supporting role in business growth strategies

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Business valuation experts can play a supporting role in business growth strategies

Among the many roles valuators play in facilitating a company’s success, one of the most overlooked may be their support in evaluating strategic investment decisions. Valuators have many tools at their disposal that can help management determine the winning investment strategy.

Methods for acting

Businesses seeking growth have several choices, including:

1. Organic or internal growth. Generally this is the slow and steady path. Strategies include building a new plant, purchasing new machinery, developing a new product or service and expanding into new markets.

Building from within isn’t without drawbacks, however. New products might cannibalize existing ones, or new target markets might reject product extensions. Opening another facility in a new location also involves a host of uncertainties, including underutilized capacity, unexpected sources of competition and skilled labor shortages.

2. Mergers and acquisitions (M&As). Buying another company is the fast track for growth. M&As typically provide assets and an established track record, including immediate cash flow, an assembled workforce, a pre-existing client base and customer referrals.

They make the most sense when the value of the combined entity is greater than the sum of its parts, as in a strategic purchase. Strategic value represents the value of a business to a particular investor based on that investor’s investment requirements and expectations.  For such buyers, acquisitions typically create value via economies of scale, operating synergies and cross-selling opportunities. Acquisitions don’t always pan out, however. Incongruent corporate cultures, incompatible operating systems, unrealistic value estimates and seller misrepresentations can lead to failure.

3. Joint ventures. Joint ventures and other contractual relationships, such as licensing and franchising, allow businesses to grow with minimal capital infusion. By starting slowly, two organizations can test their congruence and, if compatible, add incremental layers over time. Nevertheless, conducting financial due diligence is critical.

Using financial tools

Businesses facing growth opportunities may have limited resources to pursue all of their ideas. When prioritizing and selecting expansion alternatives, projected financial statements are useful.

However, projections ignore the time value of money because, by definition, they describe what’s going to happen given a set of circumstances. So it’s difficult to compare detailed projections against other investments a business might be considering. Valuators, therefore, use other financial tools — such as net present value (NPV), internal rate of return (IRR) and accounting payback period calculations — to generate comparative metrics.

In an NPV analysis, a valuator projects each alternative’s expected cash flows. Then he or she discounts each period’s projected cash flow to its present value, using a discount rate proportionate to its risk. If the sum of these present values — the NPV — is greater than zero, the investment is worthwhile. When comparing alternatives, higher NPV is generally better.

IRR relies on the same data as NPV. But it computes the required return that results in a zero NPV. A valuator compares a company’s IRR to pre-established hurdle rates (often the cost of capital). For example, if a new product line is projected to generate an IRR of 20% and the hurdle rate is 15%, the new product makes sense. When comparing competing alternatives, the one with the highest IRR is typically preferred.

Finally, valuators may use the accounting payback period tool to estimate how long an investment will take to recoup its initial cost. Using this tool, the payback for a machine that costs $200,000 and generates $40,000 in annual incremental profits would be five years.

Understand the valuation expert’s role

Clearly, poor investment decisions can lead to bankruptcy. So business owners can benefit from understanding the supporting role valuators can play in helping their companies pursue the growth strategies most likely to succeed.