Growth in Future Earnings
In our hypothetical, Shoe Co. management provided the expert with historical financial data for 2014 through 2018, and a five-year forecast through 2023 (the Projections). The Company’s financial data presents typical income statement items, including revenue; cost of goods sold (COGS); operating expenses; and earnings before interest, taxes, and depreciation and amortization (EBITDA). EBITDA is a commonly used profit measure in the valuation of a business because it provides insight into a company’s ability to generate earnings from its core operating activities. While Shoe Co.’s annual EBITDA is not the same as the cash flows generated by the Company’s operations each year, it can serve as a useful proxy.
The expert’s primary objective in analyzing Shoe Co.’s historical and projected financial performance is to assess the Company’s ability to generate earnings and cash flow in the future. His analysis of Shoe Co.’s financial data includes two principal steps. The first step looks inward and compares assumptions about the future to actual results. The second step looks outward and compares these historical and projected results to external benchmarks.
Analysis of historical and projected trends. This inward-looking analysis uses two perspectives: vertical and horizontal. The vertical analysis focuses on financial metrics up and down the income statement each year, whereas the horizontal analysis focuses on similar metrics across multiple years. As illustrated in Figure 1, the vertical analysis primarily seeks to analyze the Company’s income statement data “at the margin.” In other words, the expert seeks to determine the destination of every dollar of revenue generated from the sale of Shoe Co.’s products. The expert finds that in 2018 nearly 53 percent of revenue relates to COGS, which primarily includes product-manufacturing costs, and 38 percent relates to operating expenses. Operating expenses include selling and marketing (S&M), product development, distribution, employee compensation, and other general and administrative (G&A) items.
Figure 1: Vertical Analysis
For every dollar of revenue generated by Shoe Co. in 2018, the Company ultimately realized nearly nine cents of EBITDA.
The usefulness of these margins is limited when viewed in isolation. It’s only after adding the horizontal perspective that the figures become more meaningful. Figure 2 shows how the Company’s financial results have changed over the last five years.
Figure 2: Horizontal Analysis
The expert’s analysis of the historical data yields the following top three observations:
- Revenue increased every year, but the rate of growth declined each year.
- Gross profit margins declined each year by an average of 80 basis points (i.e., 0.8 percent of revenue).
- EBITDA experienced a modest degree of fluctuation, ranging between $2.0 million and $2.2 million.
The expert now turns his attention to the Projections. Figure 3 shows that Shoe Co. management expects to experience relatively strong revenue growth rates and expansion in EBITDA margins compared to 2018 levels.
Figure 3: Projections
The expert’s analysis of the Projections yields the following top three observations:
- Projected revenue growth rates are generally comparable to the Company’s historical experience; the higher growth rate in 2019 is impacted, at least in part, by the relatively low growth rate recorded in 2018.
- Future gross profit margins continue their declining trend by an average of 50 basis points each year.
- Operating expense margins decrease 346 basis points over the forecast period (from 38.0% to 34.6%).
Comparison to external benchmarks. Further insight into the Company’s financial performance can be gleaned when its financial data are compared to external “benchmarks” that might be available. The primary purpose of this analysis is to determine whether the Company’s results are favorable, comparable, or unfavorable when viewed against those benchmarks.
The most commonly used external benchmarks come from publicly traded companies that are deemed by the expert to be reasonably comparable to Shoe Co., which in this case includes companies primarily engaged in operations related to shoes. The expert notes in his report that no peer is a perfect match to Shoe Co. and that all companies have differences in terms of size, product diversity, geography, sales channel (i.e., wholesale operations versus retail stores), and other factors.
The list of factors that can be used to compare Shoe Co. and its public peers is nearly endless. The expert presents a comparison of financial metrics that correspond to many of his top three observations from the analysis of Shoe Co.’s historical and projected trends. As shown in Figure 4, the expert obtains insight into relative size (in terms of revenue), historical and projected growth (in terms of revenue and EBITDA), and profitability (in terms of EBITDA margin).
Figure 4: Public Company Comparison
The expert’s comparative analysis yields the following top three observations:
- Shoe Co. is substantially smaller than all of the public peers, representing only 1 percent of the median level of revenue among the group.
- The Company’s one-year projected growth rates in revenue and EBITDA are near the higher end of the range of the public peers.
- The Company’s EBITDA margin is below the average and median of the peer group but higher than two of its peers.
Summary. In our hypothetical, the expert makes observations that imply a two-sided impression of Shoe Co. On the one hand, Shoe Co. leaves a positive impression based on its consistent historical revenue growth rates, relatively narrow range of historical EBITDA amounts, and robust plan to record strong revenue growth and margin expansion in the future. On the other hand, Shoe Co. leaves a negative impression based on its unprecedented projected near-term revenue growth rate, downward trends in historical and projected gross profit margins, and expectation to increase its operating expenses more slowly than revenue.
The expert concludes that an expected long-term growth rate for the Company’s earnings is 3.5 percent. His selection gave consideration to the Company’s revenue growth rate in the final year of the discrete projection period (3.6 percent), GDP growth and inflation rate forecasts (which range from 3.5 percent to 4.5 percent), and the rate of return for 20-year U.S. Treasury Bonds (3.3 percent).
In the context of valuation, risk refers to uncertainty and variability. For example, if Shoe Co.’s EBITDA in 2019 could be 15 percent higher or potentially 20 percent lower than last year, then Shoe Co. could be perceived as a risky company because of its wide degree of earnings variability.
The framework for measuring risk in the valuation of a business has its foundation in empirical studies of investment returns on publicly traded equity securities. A widely used framework is the capital asset pricing model (CAPM). A detailed discussion of CAPM is beyond the scope of this article, but CAPM essentially assumes that an investor’s expected return on an equity security is positively correlated with its perceived riskiness. If a company is considered to be a high-risk investment, then a buyer of the company’s shares will require a correspondingly high rate of return to compensate him for bearing that risk.
Figure 5 shows results of the CAPM for Shoe Co.’s publicly traded peers. The percentages are labeled as “required rates of return” because they reflect what an investor “requires” as compensation for bearing the risk of owning each company’s shares. Other labels could have been used instead, including “expected rates of return,” “costs of capital,” or “discount rates.” On average, an investor buying securities of this peer group would require an annual rate of return of roughly 10 percent.
Figure 5: Required Rates of Return
The expert uses these required rates of return as a starting point for selecting a discount rate for Shoe Co. but makes adjustments to reflect the Company’s investment characteristics as compared to the peer companies. He revisits the factors analyzed in the external benchmarking analysis—relative size (in terms of revenue), historical and projected growth (in terms of revenue and EBITDA), and profitability (in terms of EBITDA margin). However, the expert adds a fourth metric, leverage, for purposes of analyzing the risk of Shoe Co. versus the peer companies. Leverage generally refers to the amount of interest-bearing debt in a company’s capital structure.
Figure 6 shows the expert’s calculations of each company’s interest-bearing debt divided by EBITDA. This “coverage ratio” is commonly used in the lending industry because it provides insight into a company’s ability to use its annual cash flow to repay (or cover) debt obligations. The ratio is positively correlated with risk because a high amount of debt paired with a low amount of EBITDA could call into question whether the company will be able to repay the debt when it comes due. Shoe Co. is debt-free in our hypothetical, which is also true for Crocs, Rocky Brands, and Steven Madden. Boot Barn and Wolverine World Wide have the highest leverage ratios at 2.8x.
Figure 6: Debt/EBITDA Leverage Ratio
The expert summarizes his comparative analysis in Figure 7. He first assesses how Shoe Co. compares to the peer companies as a group and then determines the impact on the Company’s relative degree of risk. In the case of size, the expert revisits his observation that Shoe Co. is substantially smaller than all of the public peers, representing only 1 percent of the median level of revenue among the group. Various studies document that smaller companies generally have a higher degree of risk compared to larger companies. The expert determines that the Company has a higher degree of risk compared to the public peers for this factor. The expert makes a similar determination based on Shoe Co.’s lower profitability. The expert concludes that there is no impact on risk due to the Company’s growth; he believes Shoe Co.’s lower growth rates recorded in the past are mitigated by its higher growth rates expected for the future.
Figure 7: Summary of Risk Assessment
In practice, a quantitative model like CAPM would be used to calculate an initial rate of return for Shoe Co. A final rate would then be selected by the expert after making adjustments that he deems appropriate based on his assessment of all relevant factors, including those shown above. In our hypothetical, the expert selects a rate of return of 15 percent for Shoe Co., which he notes is 5 percentage points above the median and 3.5 percentage points above the highest rate among its peer group (Boot Barn’s 11.4 percent).
In our hypothetical, the expert has assessed the Company’s ability to generate earnings in the future, as well as the degree of risk in achieving those future amounts. He concludes that Shoe Co.’s expected long-term growth rate in earnings is 3.5 percent and its required rate of return is 15 percent. As illustrated in Business Valuation 101 for Litigators, when these two assumptions are used in the “discounted future earnings method,” the expert derives a multiplier of 9.0x.
Figure 8: Derivation of Value
As the value multiplier is applied to Shoe Co.’s earnings in 2023, the indicated value of the Company as of that date (i.e., the “residual value”), together with the preceding annual earnings, is discounted to the present using the 15 percent required rate of return to produce a value of $17.84 million for Shoe Co.
Analyzing a company in a valuation context ultimately leads to assessing its growth in future earnings and degree of risk. The ability to generate strong growth in earnings generally leads to a higher value. However, the achievability of those future earnings must be assessed in light of their degree of risk. Risky earnings generally lead to a lower value due to the use of a higher required rate of return.
The expert in our hypothetical analyzed several factors impacting Shoe Co.’s earnings growth and degree of risk and ultimately determined that the “right” multiplier for Shoe Co. is 9.0x.
The logical follow-up questions are as follows:
- How do we know that the expert is correct?
- Is an alternative opinion more reasonable and appropriate for Shoe Co.?
The answer to these and related questions will be the subject of the third and final article of this series, which will discuss the most important factors on which to concentrate when reviewing an expert’s valuation report.
Marc Asbra is a managing director at Stout Risius Ross, LLC, based in Los Angeles, California.