Why Firm Valuation Is the Key Metric

Last month we discussed the importance of having the correct key “win” metric for your business. I gave my view that the best one measure is increases in firm valuation or market value. In this article will discuss why it is the best measure from my view. The next article will discuss how firms become market value creators and growers.

Firms that have a track record of growing their valuation attract the best employees and have lower cost of capital because they are less risky. These firms proactively upgrade their capabilities for the next round of profitable revenue growth before rivals do. They are valued places in which to work.

In 1998 the following pairs of publicly traded firms were roughly equal in their market value (stock price times number of shares outstanding): Microsoft versus Apple, Coca Cola versus Pepsi, Cisco versus Bay Networks, General Electric versus Westinghouse, Nike versus Reebok, Yahoo versus Excite and Infoseek, Mattel versus Hasbro, The Gap versus The Limited.

Over the course of the next ten years, Microsoft, Coca Cola, Cisco, General Electric, Nike, Yahoo, Mattel and The Gap grew their market value an average of seven times over each of their rivals. But notice since the end of that ten-year growth period, Microsoft has declined while Apple has zoomed to be a value creator. So nothing is carved in stone.

What caused these dramatic differences in firm value creation? This is called value migration and is caused by those top management teams seeing changing customer priorities and revenue and profit patterns in their industries earlier than their rivals and who put new business designs in place to capture the lion share of the new valuation that could be captured.

This article will borrow from one of my favorite authors and consultants, Adrian Slywotsky, and I will synthesize his great work over the last twenty years. His books like Value Migration, The Profit Zone, Profit Patterns and more have deeply influenced my thinking and practices then and now.

General Approaches to Valuing Your Firm

The general approach I like follows as it applies to both publicly traded and private for-profit firms. Your firm’s market value is determined by four key measures and their desired direction, up or down:

  1. Return on Sales – Up and equals earnings before interest and taxes (EBIT) divided by sales
  2. Profit Growth – Up and is projected growth in EBIT over the next five years
  3. Asset Efficiency – Down and equals (Assets – Cash and Equivalents – Accounts Payable) divided by sales
  4. Strategic Control Index (SCI) – Up and is from 10 (being great) to 1 (being terrible). Your Strategic Control index, discussed below, is comprised of past decisions that allow your Return on Sales and Profit Growth to be protected as far into the future as possible
  5. Market Value to Sales – Up and is (Shares Outstanding X Stock Price) divided by sales.

Your Strategic Control Index

Asset Efficiency is good to great if the assets you employ in your business are the minimum to get the job done. Throwing money at increasing assets is a destroyer of market value.

Your Strategic Control Index is very close to Warren Buffet’s notion of creating an “economic moat” around your business that protects your ability to earn a profit as far into the future as possible. Scores 10 through 7 are great to good. Scores of 6 or 5 are average. Scores of 4 to 1 are not good. Examples of things leading to a great SCI score are your firm:

10 Owns the industry standard (Microsoft, Oracle)

9 Leads changes in the industry structure power relations (Intel, Coke)

8 Has a string of super dominant positions (Coke internationally)

7 Owns the customer relationship (General Electric)

6 Has a good brand, trade mark or copyright (Coke, Pepsi, Apple)

5 Has a two-year product development lead (Intel)

4 Has a one-year product development lead (Many)

3 Is a commodity with a 10 to 20% cost advantage (Nucor Steel, Southwest Airlines)

2 Is a commodity at cost parity (Countless)

1 Is a commodity with a cost disadvantage (Countless)

So the “winners” in paragraph four above all outperformed their rivals by a huge degree along the first four measures. These in turn lead to the highest Market Value to Sales measures compared to those rivals. These measures are hard to “game” and that is why I think firm valuation or market value are the best “Win Metrics” for your business. Note your firm may not be able to proactively affect all of these scores, but do your best on as many as you can.

But these measures are lagging indicators. What is needed are the leading approaches and decisions that produced the great measures in the first place. Market value creators and growers create unique business designs to align the organization to capture the lion share of new market value that can be created. This will be the topic of the next article.

This article is part of a series on what causes a firm’s value to increase

Bill Bigler is Director of MBA Programs and associate professor of strategy at LSU Shreveport. He spent twenty-five years in the strategy consulting industry before returning to academia full time at LSUS. He is involved with several global professional strategy organizations and can be reached at bbigler@lsus.edu and www.strategybest.com