How to Evaluate The Growth Potential of Your Business
Let’s talk about the size of your business, how quickly it is growing, and the impact those two variables have on your valuation.
First – size. Data shows that the average multiple of value builder users get is 3.76 times their pre-tax profit.
However when we isolate those companies with less than a million in sales, those offers of those businesses are getting are significantly lower, 2.86.
- Businesses with $1M – $3M it’s about average (3.67)
- Businesses 3M – 10M we’re getting a better multiple (4.42)
- Those 10M+ in annual sales, they’re getting a much better multiple (5.10).
So size certainly has an impact on the multiple of your company.
The speed at which your company is growing, and the potential to scale very quickly also has a big impact on the multiple. One of the questions we ask on our survey is
“how quickly & how easily would it be to accommodate 5x the demand.”
Would that be, for example, impossible? Or would it be very easy?
Again for the lifetime of the value builder assessment tool, 3.76 is the average multiple against pre-tax profit.
For those who said it’d be impossible: imagine a law firm; if they were to take on 5x more cases, they’d have to hire 5x more lawyers, then train 5x more lawyers, etc. – it’d be virtually impossible to handle 5x demand very quickly. Those businesses are getting much lower multiples when compared to those businesses that said it’d actually be relatively easy.
Now imagine a software company or a manufacturing company that could accommodate a lot more demand without incurring a lot more expenses – those businesses are getting much better multiples.
The reason these factors are driving and manipulating the value of your company comes back to what a buyer is buying when they buy your company. As much as we want to think they’re buying our brand or our reputation in the community, in fact, what a buyer is buying is your future stream of profits.
Therefore, growth potential will have acquirers pay more if:
#1 your future stream of profits is growing, and
#2 the estimates of how quickly you’ll grow that future stream of profits is reliable. And again this comes back to the math we looked at when we talked about Discounted Cashflow.
If you recall, we looked at a business with $100,000 in pretax profit. A financial buyer would look at the rights to that 100k profit in the future and say, “what am I willing to pay today for the rights of that profit in the future.”
If the investment threshold that the investor wants is a 15% return on their money, they would spend $86,000 today for the rights to $100,000 a year from now. If their annual expectations for a return are 15%, then it’s simply $100,000 divided by 1.15.
If you then forecast out this company into the future just making exactly the same amount, $100,000, each year the acquirer must wait for their money, the price gets discounted by that number of years. Therefore in year 2, the $100,000 gets discounted by 1.15 twice. And then if you project out 10 years into the future, you’ll notice that you’ve got a flat line of growth, even though we’ve got a 15% discount rate which is a very charitable good for-the-entrepreneur, not so good for the acquirer, discount rate, the valuation is relatively modest.
Now let’s look at a business that is growing very quickly, the impact of fast growth potential, and how that really impacts the overall value of a business. Higher growth potential increases the value of a business.
This business is growing at a rate of 20% each year, for the next 10 straight years, and the acquirer is placing a very low discount rate meaning that they believe your future stream of profits is very reliable. There is something you’ve done or told them that makes them believe that it is very likely you are going to achieve these growth goals. This means you are going to get a very high multiple for your business.
Today, these two businesses I’ve just shown you are generating $100,000 in pretax profit. One is growing very quickly and has made the case to the acquirer that this growth rate is very reliable. The other company shows that their future stream of profits is reliable, but it is not growing. This ultimately has a big impact on the valuation of your company.
The #1 sporting analogy we get is running a marathon. It’s a long slow slog of a race, and the exit is the equivalent of crossing the finish line. As hard as it is for us to realize, the buyer is actually sitting, anticipating their race on the finish line. So the very company that is going to buy your business is also going to run a marathon, but for them, it is the starting line – they’re coming to it with all sorts of energy and enthusiasm and hopes and dreams about what your company can achieve. The better story you can show about your business growth potential, the more valuable business you will have.
The bigger and brighter future you can paint for them the more valuable your business is going to be in their eyes.