- July 29, 2022
- Posted by: Ramkumar
- Category: Posts
Valuing A Business By Customers
In the 𝐈𝐓 𝐬𝐞𝐫𝐯𝐢𝐜𝐞𝐬 𝐢𝐧𝐝𝐮𝐬𝐭𝐫𝐲, the majority of the M&A transactions are usually 𝐛𝐨𝐥𝐭-𝐨𝐧 𝐝𝐞𝐚𝐥𝐬 𝐭𝐡𝐚𝐭 𝐟𝐨𝐜𝐮𝐬 𝐨𝐧 𝐚𝐜𝐪𝐮𝐢𝐫𝐢𝐧𝐠 𝐬𝐩𝐞𝐜𝐢𝐟𝐢𝐜 𝐜𝐚𝐩𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 𝐚𝐧𝐝 𝐜𝐮𝐬𝐭𝐨𝐦𝐞𝐫𝐬. Thus, the deal size is smaller than a scale acquisition where the focus is maximising cost synergies.
Thus, when we value such target companies, it is better to value the target firm not as a whole but as the target per customer value.
Over the weekend, i tried to 𝐛𝐮𝐢𝐥𝐝 𝐚 𝐦𝐨𝐝𝐞𝐥 𝐟𝐨𝐫 𝐯𝐚𝐥𝐮𝐢𝐧𝐠 𝐚 𝐭𝐚𝐫𝐠𝐞𝐭 𝐜𝐨𝐦𝐩𝐚𝐧𝐲 𝐩𝐞𝐫 𝐞𝐱𝐢𝐬𝐭𝐢𝐧𝐠 /𝐧𝐞𝐰 𝐜𝐮𝐬𝐭𝐨𝐦𝐞𝐫 and observed some striking results.
For this model, i assumed a small IT service company with substantial F500 companies.
Count of existing customers = 15
Relationship with existing customers = five years
Engagement model = Project-based
WACC of target = 15%
Average Revenue/Customer = $2.5 million
Avg.Direct Costs/Customer excluding bench = $0.83 M
Avg.Contribution Margin/Customer = $1.67 M
𝐓𝐡𝐮𝐬, 𝐭𝐡𝐞 𝐟𝐢𝐫𝐦’𝐬 𝐩𝐫𝐞𝐬𝐞𝐧𝐭 𝐯𝐚𝐥𝐮𝐞 𝐰𝐢𝐭𝐡 𝐞𝐱𝐢𝐬𝐭𝐢𝐧𝐠 𝐜𝐮𝐬𝐭𝐨𝐦𝐞𝐫𝐬 = $𝟖𝟑.𝟖𝟏 𝐌.
Now, the target company growth projections come from acquiring new customers.
Thus, the CAC/new customer = $0.5 M
In the next 10 yrs, i assume the Contribution margin/new customer and CAC/customer will grow at an inflation rate of 3.5%
Currently, New customer additions = 2, and i think that the growth in new customer additions for the next 10 yrs = 10%
Forecasting this model to the next 10 yrs and discounting back at a WACC of 15%, i get the firm’s value from existing and new customers.
𝐅𝐞𝐰 𝐨𝐛𝐬𝐞𝐫𝐯𝐚𝐭𝐢𝐨𝐧𝐬 𝐟𝐫𝐨𝐦 𝐭𝐡𝐞 𝐚𝐧𝐚𝐥𝐲𝐬𝐢𝐬
1)When the target has 𝐥𝐨𝐧𝐠-𝐭𝐞𝐫𝐦 𝐜𝐨𝐧𝐭𝐫𝐚𝐜𝐭𝐬 𝐰𝐢𝐭𝐡 𝐢𝐭𝐬 𝐜𝐮𝐬𝐭𝐨𝐦𝐞𝐫𝐬, it locks in the customer. Here, the 𝐝𝐢𝐬𝐜𝐨𝐮𝐧𝐭 𝐫𝐚𝐭𝐞 𝐢𝐬 𝐧𝐨𝐭 𝐭𝐡𝐞 𝐭𝐚𝐫𝐠𝐞𝐭’𝐬 𝐖𝐀𝐂𝐂 𝐛𝐮𝐭 𝐭𝐡𝐞 𝐫𝐢𝐬𝐤-𝐟𝐫𝐞𝐞 𝐫𝐚𝐭𝐞. In my view, the 𝐦𝐨𝐫𝐞 𝐭𝐡𝐞 𝐚𝐧𝐧𝐮𝐢𝐭𝐲 𝐫𝐞𝐯𝐞𝐧𝐮𝐞𝐬, 𝐭𝐡𝐞 𝐥𝐨𝐰𝐞𝐫 𝐭𝐡𝐞 𝐫𝐢𝐬𝐤 𝐚𝐧𝐝 𝐡𝐢𝐠𝐡𝐞𝐫 𝐭𝐡𝐞 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐜𝐮𝐬𝐭𝐨𝐦𝐞𝐫.
2)If the 𝐂𝐀𝐂/𝐧𝐞𝐰 𝐜𝐮𝐬𝐭𝐨𝐦𝐞𝐫 = 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐦𝐚𝐫𝐠𝐢𝐧/𝐧𝐞𝐰 𝐜𝐮𝐬𝐭𝐨𝐦𝐞𝐫, 𝐭𝐡𝐞 𝐢𝐧𝐜𝐫𝐞𝐦𝐞𝐧𝐭𝐚𝐥 𝐠𝐫𝐨𝐰𝐭𝐡 𝐢𝐧 𝐯𝐚𝐥𝐮𝐞 𝐟𝐫𝐨𝐦 𝐚 𝐧𝐞𝐰 𝐜𝐮𝐬𝐭𝐨𝐦𝐞𝐫 𝐢𝐬 𝐳𝐞𝐫𝐨. Thus, firms with a lower CAC/customer, lower cost structure, and higher pricing power will have a higher value.
3)At the 𝐬𝐭𝐚𝐛𝐥𝐞 𝐠𝐫𝐨𝐰𝐭𝐡, 𝐭𝐡𝐞 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐭𝐚𝐫𝐠𝐞𝐭 = 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐞𝐱𝐢𝐬𝐭𝐢𝐧𝐠 𝐜𝐮𝐬𝐭𝐨𝐦𝐞𝐫𝐬.
In my view, this model gives me 𝐛𝐞𝐭𝐭𝐞𝐫 𝐢𝐧𝐬𝐢𝐠𝐡𝐭𝐬 𝐢𝐧𝐭𝐨 𝐭𝐡𝐞 𝐭𝐚𝐫𝐠𝐞𝐭 𝐜𝐨𝐦𝐩𝐚𝐧𝐲 𝐛𝐞𝐜𝐚𝐮𝐬𝐞 𝐢𝐭 𝐥𝐢𝐧𝐤𝐬 𝐭𝐡𝐞 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐝𝐫𝐢𝐯𝐞𝐫𝐬 𝐨𝐟 𝐭𝐡𝐞 𝐟𝐢𝐫𝐦 rather than looking at financial drivers.
This model is simplistic, but we can tweak the model for the customer churn and degrowth of existing customers.