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Technology Cup Man of the Match

With World Cup fever gaining strength, I started thinking about the world’s largest companies and their leaders. If there was a World Cup of technology companies and we were in the final game of the tournament, who would be man of the match (soccer's version of MVP)?

The top two market cap technology companies these days are Microsoft and Apple. At today’s closing prices (June 14) their market caps are $223B and $231B with Apple now in the lead. If we compare these two “teams,” who is the player with the greatest influence? Regrettably, even though I live in Microsoft’s backyard, I don’t think there are any finalists for this honor at the Redmond software complex. Microsoft’s stock price has been virtually flat for the last ten years. Apple’s stock has gone up nearly ten-fold over that same period.

According to a recent article (June 7, 2010) in Network World, over the last decade, Microsoft has spent $71 billion on R&D and made over 100 acquisitions. Apple, on the other hand, has invested only $8 billion in R&D and acquired 11 companies. In other words, Microsoft has outspent Apple over nine times on new or future products and services, and yet the market has rewarded Apple far more prodigiously than Microsoft.

The key difference according to the article is innovation. Apple has focused on the user while Microsoft has been bogged down adding features. Innovation will trump evolution every time.

Even though I grew up in Silicon Valley, Apple's home turf, I live in Redmond and very much want my giant corporate neighbor and many of my friends to succeed. Unfortunately, the Apple team has the momentum and their fans are screaming and blowing loudly on their vuvuzelas. Their team is putting on quite a show and their players are passionately expressing their talents out on the field. In contrast, the Microsoft side of the stadium is rather quiet as our team plays a methodical and predictable style of soccer. The scoreboard is showing ten-zip.

Oh, I almost forgot. The man of the match has to be Steve Jobs. He’s the guy who has remained laser-focused on the importance of design and functional elegance. The result has been products that have an almost cult-like following.

Fortunately, in the real world, the tournament is not over. I want my home team to score goals, win games, get the fans fired up, and re-learn how to be a winner.

Private Company Cost of Capital

Cost of capital is an important factor in determining the value of a business. The market rewards a business that can raise money more cost effectively than its peers. Such a company is deemed to have a competitive advantage and hence a higher fair market value.

But cost of capital is more than the ability to raise money on the cheap. It also represents the expected rate of return that investor’s require based on the risk of the underlying business. In other words, cost of capital is a market driven rate balancing risk and reward.

For private companies, business valuators have long used the so-called build-up method to develop a company’s cost of capital. This method takes a risk-free rate and then adds various risk premiums – an equity risk premium, small company size premium and specific company risk premium – to determine the cost of capital. Two out of three of these premiums - the equity risk premium, which represents the premium that investors demand to invest in stock rather than a government bond, and the size premium- are determined by reference to public company data.

This approach to determining cost of capital has been argued to be inadequate for private companies since the markets for public versus private capital are much different. And yet, without the ability to access comparable private company data, there has been no alternative but to use the available public company data.

In the summer of 2009 the Pepperdine University School of Business completed a survey of the cost of capital for private companies. This survey captured the rate of return expectations for each of the private capital market segments (VC firms, private equity groups, mezzanine funds, asset-based lenders and senior lenders). The survey is being updated semiannually with the latest report dated February 2010.  

The availability of private company return data has enabled development of a new model to value private cost of capital. For business valuators and owners alike, this is an exciting development that will provide more meaningful appraisals of private companies and thereby guide owners to making more intelligent decisions regarding their use of funds.

As a private company business owner, board member, or CFO, it’s important that you get a handle on your company’s cost of capital. In so doing you will have gained new insight into how the market views your risk/reward equation. This not only allows you to better set valuation expectations, it allows you the means to determine how to change your company’s profile to tip the scales in your favor.

Impacting Business Value: Cash Flows

Like the waterfalls that cascade into Yosemite Valley, cash flows are the life source for a business. This becomes especially apparent when a business runs low on cash and is forced to prune people, product lines and expenses just to survive.

The key to having cash flows that optimize the value of a business are predictable, sustainable and growing. Predictable cash flows are valuable because they provide certainty and facilitate planning. Sustainable cash flows are valuable because they are recurring and long-lived. Growing cash flows are valuable because growth is vital to any business in order to gain market share and to offset cost inflation.

Net cash flows consist of both inputs and outputs – costs and revenues. Both need to be managed in order to maximize value. The need for a disciplined approach to costs and expenses has been highlighted these last few years in response to the recession. A similar discipline should apply to an evaluation of a Company’s revenue streams in evaluating which are profitable, predictable and the most likely to be sustainable and to grow. In a typical software company, maintenance renewals may be the predictable and sustainable revenue stream, new licenses may be the growth stream, and professional services may be an adjunct profitable stream. Because of the symbiotic relationship of these streams, management may find that decisions that impact one revenue stream will impact the others. The guts of the business can be complex and messy. The management team that best understands its business and that is proactive rather than passive will be in the best position to create value.

Profitability is related to but not the same as net cash flows. In accounting terms, net cash flows are net income after tax plus noncash charges such as depreciation expense and stock option expense, less incremental working capital needs, less capital expenditure needs. What might cause net income to be high and yet net cash flows to be low or even negative? Often times the culprit is working capital. If receivables grow faster than payables working capital needs are higher and cash flows are lower. This may occur because of rapid growth of a new product, or it may occur because the company is offering liberal payment terms. It might also occur because the company has staffed up its accounting department and bills are being processed faster. The point is that, just as with costs and with revenues, working capital needs to be managed in order to optimize cash flows and the value of a business.

The common denominator with valuable and healthy cash flows is capable management. Just as grapevine pruning is needed to maintain size, shape and productivity, business management is needed to actively manage a business so that it can reach its potential.

Understanding Business Value

Wikipedia makes the rather startling assertion that business value is an informal concept for which there is no consensus on its role in effective decision-making. I say startling, because surveys consistently show that there is a tidal wave of businesses that will change hands in the next few years. If I’m a business owner who plans to retire in, say, 5 years and the sale of the business is hoped to be my nest egg, I would want to have a laser-like focus on business value. I would bet that the business owner who is attuned to value will, over the long run, make better decisions than one who is not.

It is often said that beauty is in the eye of the beholder and so too with value. Business value can be subjective and business valuation is both an art and a science. For example, when valuing a business there are different standards that can be used depending on the purpose of the valuation: fair market value, investment value and intrinsic value, to name a few. There are also a variety of valuation approaches that can be used: the income, market or cost approach. And yet, despite the variety of standards and approaches that can be used, there are some known constants that directly impact the value of most businesses.

So what factors almost always influence business value? There are at least three: net cash flows, growth, and cost of capital. You accountants out there will have recognized that these are the inputs into our good buddy the discounted cash flow model. Thats because the value of any business is the total of the expected future benefits that result from ownership.

We’ll continue this discussion by looking at these important value determinants in subsequent posts . . .