- October 6, 2019
- Posted by: Ramkumar
- Category: Strategy
Performance drives business valuations
We often hear that companies can drive higher valuations by positioning themselves as technology company even though they might be operating in other sector.For instance Uber – A transportation company was able to command a higher valuation multiple by positioning itself as a technology company.The same extends to other companies like Tesla and WeWork.
Does this assumption hold true?Can just merely changing industry labels boost a valuation of a company even though the underlying performance does not change much.
Link between Performance and Valuations multiples
- Corporate performance is inextricably linked to valuation multiples.Higher the performance, better would be the valuation multiple.
- For instance in a conventional industry like Manufacturing or packaging industry, the average industry valuation multiple would be around 15X.This might seem to be much lower than the companies in the fast growing tech sector.
- At the same time, performers in these industries deliver consistent and superior returns on invested capital by displaying higher revenue growth.This boosted the EBITDA valuation multiples of performers far higher than the industry average.
- From this, we can infer that multiples tend to be highly variable within the industries as firms within the industries display different growth rates and profitability.
There is no shortcut to Valuations
- Performance can only drive valuation multiples.There is no other shortcut to drive higher valuation.
- Hence if companies want to achieve an industry average multiple, then it must match the industry average expected performance.Changing industry labels cannot help companies to achieve higher valuation.
- The only way companies have in their control to drive higher valuations is to drive higher growth, margins and to improve capital productivity.
Conclusion
- Performance can only drive higher valuations multiples.
- In order to achieve higher multiples, firms need to revisit their business strategies, reallocate capital and resources towards high growth initiatives.
- Doing this consistently over a longer term will improve share prices and increase valuation multiples.
[…] Businesses generate value for their stakeholders by investing cash now to generate more cash in the future. The measure of the value they create is the difference between cash inflows and the cost of the investments made, adjusted to indicate the reality that future cash flows are worth less than current due to the time value of money. That suggests the amount of value a company generates is governed conclusively by its ROIC, revenue growth, and capacity to maintain both over time. A business will create value only if its ROIC is more significant than its WACC. Therefore it is crucial to every strategic and investment decision to recognize and predict what drives and maintains ROIC. In this post, I provide my insights on importance of ROIC in business valuations. […]