Key Drivers of Value - Part 1

The Value Trifecta

ValueLook Familiar?  For many who have studied finance, the above equation is probably familiar in some form or another.  The equation is known by many different names such as the Gordon growth model and capitalization model, and its numerator and denominator work with many different inputs.  Those in the valuation community associate this model with what is called the earnings approach.  The bottom line is that, no matter what inputs you use or whatever form this equation takes, this model does one thing: it converts some form of an anticipated economic benefit into value.  And your appraisal expert is using it to estimate the value of your business. 

If, indeed, this equation is one of the favored methods for determining value, which factors of the business or security does it consider?  Which aspects are most important?  Rather than just some mathematical mechanism that cranks out some conclusion, managers and business owners can use this equation to understand the key variables that drive value.  Through understanding how an investor might look at their business, managers and owners are able to use a macro view of their business to understand how process improvements and initiatives combine to drive value.  Such a global understanding of a business is essential in the development and implementation of cohesive and thorough strategy.  Take each individual variable into consideration and ask:  What is this variable trying to measure?  Let's begin:

  • Benefit Stream.  This variable is some measure of income or economic benefit that an investor can expect to receive from the subject being valued.
  • Discount Rate.  This variable is the rate of return required by an investor to compensate him or her for his/her risk in not receiving the expected economic benefit. 
  • Long-Term Growth.  This variable is the expected level of growth of the benefit stream into perpetuity. 

The top of the equation, the numerator, takes into consideration the benefit expected by the investor.  All things equal, the investor will give greater value to a larger benefit stream in relation to its corresponding revenue base.  Accordingly, this portion of the value equation takes into account the quality of the expected economic benefit, or rather the profitability of the business or security being valued.  The bottom part of the equation, the denominator, consists of two parts: the discount rate and the long term growth.  As the discount rate is the required return by investors, it seeks to capture the amount of risk unique to a specific business or security.  Often, its derivation is the most tedious and comprehensive in this equation.  The discount rate embodies many factors, such as operating strength, competitive advantage, leverage, diversity, and industry and macroeconomic factors.  The second term in the denominator, long term growth, measures the expected growth in the top part of the equation.  The long term growth rate seeks to measure the potential of the business or the security to continue to improve the size and quality of its returns. 

Now, the equation can be restated to present the relationship between these three key drivers of value in what we refer to as the value trifecta. 

Value2Ask yourself if the following sounds like a solid investment:  A highly profitable company that enjoys a significant competitive advantage and has a substantial potential for growth.  One might say that such an investment is indeed valuable.  However, any manager or business owner understands that such is easier said than done.  The key to driving value is not understanding what drives value but rather how the drivers are related Understanding that relationship is key to successfully implementing value-driving strategy. 

To begin, it is first necessary to understand the relationship between risk and growth.  Though risk essentially embodies all negative aspects regarding a business or security, its effects are crowded out by the Company's upside potential, i.e. its ability to grow.  High growth companies are typically associated with higher levels of risk because of a range of factors including lack of longstanding operating history, higher leverage, and volatile earnings.  By subtracting growth from the discount rate, we are giving credit to the business or security's ability to increase its benefit stream and enhance returns.  The difference between these two factors results in what is known as a capitalization rate.  A capitalization rate is any divisor used to convert a representative economic benefit into value. 

The equation now relates the Company's profitability to its risk and its growth characteristics.  As previously mentioned, larger economic benefits are more valuable relative to its revenue base, all else being equal.  However, the quality, or value, of those benefits is a function of profitability, risk, and growth.  Risk and growth are essentially the value leverage in this equation.  Though more profit is indeed more valuable, all else being equal, investors often treat risk and growth with more sensitivity than nominal amounts of an economic benefit.  For example, given two businesses of identical operating risk, would you rather invest in the business with larger expected benefit or a business with less nominal benefits but significantly more growth potential?  Such a question is sought to be answered by the model that has been the subject of this article. Managers and business owners can create more value at the margin by lowering operational risks and developing opportunities than by simply cutting costs and increasing profitability.  However, one must not forget that these factors are all related and that improving operational efficiency is associated with lower risk! 

In summary, the value trifecta is a whole concept whereby value is created exponentially through the implementation of a cohesive plan that seeks to improve all aspects of a business, not just one.  Want more value? Dynamic management and strategy are important keys to success.  They are key drivers of value.  Our next article in this four-part series will look at the benefit stream, another key driver of value.

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