PRIVATE EQUITY | DEMYSTIFY
3
A BASIC VALUATION MODEL
Private Equity houses look to drive growth in value, therefore, it is useful to have a basic valuation model in mind. The one that we use looks at value through four lenses:
Rationalising this, businesses that grow the fastest, that turn their efforts into profits the most readily, where the quality of those profits are the highest (ie profits readily turn into cash) and where the risks are the lowest, will be valued the most highly. So, when thinking about taking on Private Equity, it is worthwhile looking at your business through these four lenses:
Margin ;
Revenue Growth ;
Cash Conversion ; and
Risk Quotient
RISK QUOTIENT
CASH CONVERSION
REVENUE GROWTH
MARGIN
X How readily does your profit turn into cash and what could be done to enhance that X Private Equity houses use debt to reduce the cost of capital and help drive equity value. Companies with high cash conversion can service more debt.
X How ‘risky’ is your business ie how resilient is it to bad things happening X Companies that are seen as least risky are afforded high multiples. Often ‘scale’ is a proxy for safe, but visibility of earnings and good management reduces risk perception.
X How much effort (cost) do you need to make to turn your revenues into profit and what could be done to improve that X Similarly, but not so
X How fast has your
business grown and how fast could it grow in the future X Empirically, companies with the highest growth, or with the expectation of the highest growth attract the highest valuations.
visibly, companies with high margins are more highly valued by investors.
IF YOU COMBINE ALL THESE TOGETHER, YOU REACH THE HIGHESTVALUATIONS . COMPANIES SUCH AS GOOGLE AND APPLE FOLLOWTHE BASIC VALUATION MODEL AND AS A RESULT THEY’RE STILL FAST GROWING. WHEN CONTEMPLATING PRIVATE EQUITY, THINK ABOUT HOWYOU CAN DEMONSTRATE YOUR PROWESS IN THESE FOUR AREAS.
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