How could two companies in the same industry, with similar revenue and profitability, sell for wildly different multiples of earnings?
The answer usually lies in how much future growth the businesses are projecting, and how risky a buyer perceives that future growth to be.
Yesterday, I looked at how the risk associated with your future stream of profits affects your value. Today I want to tackle the other number that affects the price a financial buyer is willing to pay for your company: your projected growth rate.
To understand the relationship between growth potential and value, we need to start by remembering how a buyer calculates the value of your future stream of profits (and therefore, often, your business)
That starting point is projecting out your future stream of profits and “discounting” the present value of that money by the rate of return they expect and the time they need to wait to get their money.
For example, if you project your company will generate $100,000 of profit a year for the next 10 years, a financial buyer demanding a 15-per-cent return would “discount” the $100,000 by 15 per cent each year.
So $100,000 in profits in the first year would be “discounted” by 15 per cent, and become worth $86,957.
The second year's $100,000 would be worth $75,614, because they would take 15 per cent off for each year they would have to wait for their money.
The third year's $100,000 would be worth $65,752, and so on.
Using a 15-per-cent discount rate, a business projecting a straight $100,000 a year in profit for the next 10 years would be worth $501,878, or about five times current year earnings.
Now imagine that, instead of generating a flat $100,000 in profit for the next 10 years, you project your company’s profits to grow by 20 per cent each year in the future.
Assuming you keep the 15-per-cent discount rate constant, the business expecting a 20-per-cent growth rate over the next 10 years would be worth $1,273,207 -- more than 12 times earnings and double the business that expects its revenue to remain flat.
In summary, as an owner, you have two levers to manipulate in order to increase the value of your business for a financial buyer: how much profit you expect to make in the future, and how risky the buyer perceives that future stream of profits to be.
Special to The Globe and Mail
John Warrillow is a writer, speaker and angel investor in a number of start-up companies. You can download a free chapter of his new book, Built to Sell: Creating a Business That Can Thrive Without You.
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