How does an investor value a company?

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Customer Relationship Management business chart on a digital tabWorking on a due diligence project raised that very question. The question is this: if an investor is intending investing in a firm, how do they value that firm? How does an investor value a company in order to know if the asking price is valid.

Investors invest in the hope of returns on their investment over the coming years. Accountants would perhaps value a firm using some multiple of the average profits over the past five years – and five is a common multiple. They would claim that a business with an average EBITDA (net profit) of £2m per annum was worth say £10m.

But is this value valid? Will the company make the same profits for a future owner?

These questions are answered by the process of due diligence.

About Added Value

Added value generates profits. One has to ask therefore where the value is added. Firstly a firm makes profits as a result of the unique efforts of its people. This added value is hopefully unique because it’s difficult for another company to copy what the firm does. If it can be copied easily, the firm is worth less. Staff are said to have competence if their effort can be applied in some unique way to achieve great things.  And competence gives added value to goods and services sold. So value equates to staff with high competencies using sound processes to do great things.

Secondly, a company makes profits as a result of its access to its markets. This is generally something that is built up over the years and might include the firm’s reputation. This allows the firm to push more products and services down to its customers and hence grow without actually growing its customer base.

And finally, the firm makes profits through the uniqueness of its products. This is why firms invest in research and development. They develop products (and services) that are well differentiated from others and so they enjoy continuing sales and high margins from the high value generated. If the firm doesn’t own it’s own products, value comes from the exclusivity of distribution contracts with those firms that do own the products. If the firm doesn’t own it’s own products, the margins that it can enjoy are less, reflecting a lower added value.

Case of a Reseller

So let’s take a distributor of technical products. It sells products that it buys from manufacturers. These manufacturers are responsible for doing everything needed to get the products saleable in the market. And they are responsible for interpreting the market need.

So for a reseller of technical products, where is the added value? Is it in people, markets or products?

On the face of it the accountants are right. In economist’s speak, “all else being equal”, the past will be a guide to the future and the firm will continue to make profits.

But things are not always equal. Markets seldom remain the same. Customers change their buying habits and the firm does not own it’s own R&D and cannot therefore develop new products to react to market pressures. Competitors may develop better offerings. And others like regulators change the competition environment.

With change in customer needs come demands on the firm’s staff. If indeed all things are equal, staff competencies are as they were. But if the environment is changing, staff need to have the flexibility to respond – and that needs enhanced skills and knowledge.

So we come back to the question – what gives a re-seller firm its value?  What allows us to assert that future profits will be like those before? The answer lies in the potential of its people and its access to markets and products.

How does an investor value a company?

To evaluate the firm, we need to consider its declared strategy. If the firm believes it will be business as usual, due diligence needs to establish that the environment will not realise surprises. It would of course be a strange state of affairs if management were projecting no change whatsoever. If on the other hand the environment is likely to change, due diligence needs to establish that the firm has the capability to react.

So due diligence must evaluate the firm’s staff and their competencies, the firm’s markets and their ability to support the business plan and the firm’s products and their ability to meet customer needs now and the future. And if the firm develops its own products, due diligence must establish the staff competencies in product design and realisation.

In the case of our reseller, due diligence must analyse the business plan considering the likely environment. Due diligence must establish that the staff have the competencies needed to meet the business plan given the environment. And due diligence must establish the likely future market for the products.

In the case of a reseller, due diligence must establish that there is a sound agreement with the product manufacturer and that it is committed to develop it’s products to meet the likely future environment. In this case, it’s the manufacturer that becomes the focus to secure future goods to re-sell.

So a company might be worth what the accountants say. But that remains to be confirmed by due diligence focusing on people, markets and products.

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