"No matter how brilliant your mind or strategy, if you're playing a solo game, you'll always lose out to a team."
— Reid Hoffman, Founder, LinkedIn
In two prior articles we explained valuation multiples and how to use them, and then explored different ways to calculate the value of a company via enterprise value. Those articles provide metrics and tools to help business managers think through such questions as:
- What is my business worth today?
- What are the right valuation multiples for assessing the performance of my organization?
- How can enterprise value calculations help me evaluate opportunities to raise growth capital or accelerate business expansion via acquisitions?
However, all those metrics, tools and questions are merely steps that bring you closer to a greater goal: increasing the value of the business for shareholders and other stakeholders. And while it's good for a business's executive leadership to use valuation multiples and enterprise value effectively, high-value businesses are built by teams, not one or a few individuals — as the opening Reid Hoffman quotation implies.
Unfortunately, when it comes to financial acumen, many organizations aren't making it a team game. This article proposes techniques to change this — to help business managers use their knowledge of valuation multiples and enterprise value to get team members throughout the organization aligned behind strategy and execution in a way that maximizes the value of the business.
- The entire organization — not just the CEO and CFO — should be aligned around key financial metrics that drive business value.
- Picking the right metrics and communicating them consistently makes it easier for team members to understand how their efforts increase business value.
- The right metrics can also help shape business planning and forecasting.
- Good forecasting demands not one or a few scenarios, but sensitivity analysis across the range of possible outcomes.
- Incorporate your chosen metrics into shared dashboards to track progress against your forecasts.
Aligning the Organization on Key Financial Metrics
Depending on your business, you may need to use different valuation multiples. For example, some companies should focus on growing revenue, while others should focus on profit, and different industries can be evaluated better based on certain multiples and not others.
Once you've determined the correct multiples for your organization, the next step is to pick the right public companies to make a useful comparison. For example, software companies might use the SaaS Capital Index to look at public-company SaaS valuations. If you lead a SaaS business, those metrics could be very helpful because they're derived from a cohort of public SaaS businesses. But if you're running a furniture ecommerce startup, SaaS benchmarks aren't so helpful. You'll want to look at other, more similar, ecommerce businesses, such as Wayfair and Overstock.
Mapping those Metrics to EV and Valuation Multiples
Let's play out the example of an ecommerce furniture startup. Having zeroed in on Wayfair and Overstock as reasonable sources for comparison, the next step is to decide on the most relevant valuation multiples. You can pull up valuation reports for both companies at a variety of financial websites and look at many of the metrics discussed in those earlier articles.
The next step requires a bit of analysis that is part art and part science.
Table A: Wayfair Valuation Metrics
Table B: Overstock Valuation Metrics
As the lack of trailing price-to-earnings (PE) in Tables A and B show, Wayfair and Overstock were both operating at a loss for much of the last year; but as the EBITDA line shows, both became profitable during 2020.
Still, their enterprise values and market capitalizations were positive throughout the period covered by the tables, which indicates that the consensus of investors is that both companies are growth stocks that should be valued based on revenue, not profit. Because our hypothetical ecommerce furniture company is a startup, its executives will want to ask themselves if they're comfortable enough with their growth rate to also focus on revenue-based multiples. If so, great. If not, they'll have to look for other relevant companies for valuation comparisons.
But Wayfair and Overstock have very different valuation multiples — we'll have to dig deeper if we want to make a good match for our startup. Looking at the companies' annual income statement summaries (Tables C and D) helps to refine the choice. Wayfair's revenue has nearly tripled from full-year 2016 to 2019, but Overstock's stalled and then fell. That explains those very different EV/revenue multiples we saw in Tables A and B, with Wayfair ranging from 2.72 to 7.37 and Overstock at only 0.30 to 3.90.
Table C: Wayfair Annual Income Statement Summary
|Cost of revenue||2,572,549||3,602,072||5,192,451||6,979,725|
Table D: Overstock Annual Income Statement Summary
|Cost of revenue||1,468,614||1,404,205||1,467,684||1,166,325|
Because our furniture startup has a growth rate similar to Wayfair's, this tells the executive team that every dollar of top-line revenue growth likely drives the company's value up by between $2.70 and $7.37 — not too bad.
Given that Wayfair's and Overstock's most recent quarterly multiples were 7.37 and 3.90, respectively, you could safely estimate that it's between $4 and $7 of value. That's a valuable insight that drives a growth-focused business strategy — and the more executives and staff throughout the company who understand that insight and what it means, the better.
Of course, it's always important to do a "sanity check" and to keep an eye on the future. That means looking at a few other companies in adjacent retail areas, and more mature companies, too. In this case, a comparison with Costco — a mature, profitable retailer with both in-person and online stores and an enterprise value of $153 billion in mid-2020 — could serve both purposes. Costco's EV/revenue multiple has ranged from about $2.69 to $3.51, which is lower than Wayfair's but close enough to pass the sanity check.
Therefore, the furniture ecommerce startup's executives may decide to start focusing on Costco and Wayfair's EV/revenue ratios as key metrics that they can review regularly with their team to help contextualize the revenue that they're generating and the importance of growing revenue to make the business more valuable.
Applications in Financial Modeling
However, this isn't simply a backward-looking exercise. It also becomes important in developing plans and forecasts.
For example, all other things being equal, if you're optimizing for growing shareholder value and have enough capital to ensure you don't run out of cash — two important caveats — then you want to think about your forecast based on the question of how to grow top-line revenue even at the expense of short-term profits.
Again, this is not an individual decision, but one the entire leadership team should be aware of and participate in. When thinking through marketing and sales growth initiatives, for example, if the team has this financial insight, they will all understand why those investments are being made and the importance of their roles in the business strategy. Everyone will be tasked to grow revenue as quickly as possible without tripping other financial guard rails.
Nowadays, this kind of financial acumen should not be the domain of only the CFO and CEO. Everybody in the organization should understand and be thinking of these metrics.
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Instead of forecasting your business around one set of assumptions, it's a best practice to do scenario planning — forecasting based on multiple different possibilities.
VC firms typically encourage portfolio companies to talk about best, average and worst-case scenarios. Again, continuing with our ecommerce startup example, you could then evaluate each scenario based on key questions such as:
- How does this impact my end-of-scenario (quarter or year) revenue?
- What is the growth rate of revenue over this quarter or year?
- Based on valuation multiples of 2.5x to 4x, how much value did the company create this quarter?
And the caveats: Are we comfortable with the minimum cash balance and gross burn that each scenario will create?
Once you've zeroed in on what you believe are optimal, best- and worst-case scenarios, it's often helpful to look at those as more than independent data points. Looking at how many regular increments impact business performance across an entire scenario is the job of sensitivity analysis.
For example, if the ecommerce startup team believes revenue will grow somewhere between 5% (worst case) and 12% (best case) over the next year, we'd encourage them to analyze the effect on all their key financial control variables — in this case, primarily low cash balance and gross burn — at 1% increments, monthly. They can then look at the sensitivity of their forecasts to ensure they're comfortable with the investments they're making across those possibilities.
Finally, once you've developed forecasts with multiple scenarios you're comfortable with, the last step is to keep this information top-of-mind as the team executes against the strategy. This is where dashboards become important.
Showing actual performance against your best case/worst case forecasts can help the team understand how they're doing. And because you've increased your leadership's awareness of how increasing performance increases company value, this won't just be some esoteric financial concept but one whose impact on the business they fully comprehend. This can be incredibly motivating, especially if they have some ownership stake in the company through vehicles like restricted stock units or stock options.
Use Valuation Multiples to Drive Business Performance
There are, of course, many more ways in which various aspects of a business can be analyzed through the lenses of valuation multiples and enterprise value. But the simple examples in this article should show clearly how a business' executive team can go through a process of selecting valuation metrics that drive a value-building business strategy, use them to help shape business planning and forecasting, align their broader teams around them, and then use them in dashboards to track the business' progress. These are some of the best practices that lead to truly high-performance businesses.