I have learned (the hard way) that our behavior and decisions are shaped by how we think.
When it comes to something we put time and effort into, we tend to become irrational when assessing the quality.
This is especially true when the outcome is worthwhile, like raising funds or selling a business.
We, humans, are inclined to think that our company deserves to raise tens of millions of dollars or be valued 10x its revenues.
Photo by Arlington Research on Unsplash
The best entrepreneurs I know have frameworks helping them understand how things work.
High-Quality businesses command High-Valuation multiples.
Today, I'm sharing a framework designed to help you understand the main feature of a High-Quality business and a simple way to check if you have one.
Assessing the quality of a business is often a matter of perception that can be manipulated regarding the skills of an M&A dealmaker. It is the art component of the job.
I believe the best arts are built on a deep and robust scientific groundwork (I have an engineering background 😅 ). For example, I am breathless before the science behind the perspective of a painting.
In business, the quality of a company evaluation must come first from tangibles underlying principles.
What makes a business valuable is its ability to generate future cash flows — ideally a lot of it, with a high degree of certainty and for a long time. It’s an axiom of business.
The lowest common denominator of all High-Quality businesses is a sustainable earnings power.
An earning power is the ability of a business to generate profits either :
by being the first to solve an unmet needs,
by selling at a higher price than its competitors,
by producing at a lower cost than the competition.
Sustainability refers to the competitive advantage or the ability of a business to maintain its margins and market share over the long haul.
A sustainable earning power enables a business to produce a high level of growing, predictable, and durable cash flows.
Assessing a company's earning power is simple, but the sustainable nature of an earning power is not.
However, there is a test making simple the sustainability evaluation of a business that already has an earning power.
This test has the same characteristics as a Covid-19 antigenic test. Very effective in detecting businesses with competitive advantages and even more so in discriminating against those who do not.
This test involves calculating a company’s historical Return On Invested Capital (ROIC) and compare it to its Weighted Average Cost of Capital (WACC).
The ROIC measures the profitability of equity.
In other words, ROIC quantifies the profits a company can generate for each dollar of capital invested into the operations in the form of a percentage.
How to calculate ROIC
Return On Invested Capital Formula
The numerator of ROIC is Net Operating Profit After Tax (NOPAT), which measures the cash earnings of a company before financing costs.
NOPAT = EBITDA x Corporate Tax.
Invested capital is the denominator of ROIC, the number of net assets a company needs to run its business.
Invested capital = Net fixed assets + Net Working Capital
Generally, the higher the ROIC, the more likely the company will achieve sustainable long-term value creation. The minimum ROIC is set between 10 and 15%.
However, this metric must be compared to your company's cost of capital (WACC). This exercise aims to better understand how efficiently your company has utilized its operating capital.
If you rely heavily on equity investors to fund your operations, your WACC is around 25%. To consider that your business has a competitive advantage, your ROIC must be above 25%.
In the end, the information provided in this article has given you an excellent introduction to the underlying principle of a High-Quality business and a fast and easy way to assess whether or not you have a High-Quality business.
I'll share another simple and rapid test assessing the nature of your competitive advantage in case you have objective evidence of one.
Thanks for reading!
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