How Simply Increasing your Profit may not Increase the Value of your Business

I can clearly remember a situation many years ago, when a business manager said to me, that once your overhead costs are covered, any sale that generates margin in excess of your variable costs, is “good” business.  The concept didn’t sit well with me at the time. The business had lackluster performance, so his approach obviously was not working.  Since then, I have realized that a business can increase its earnings while not necessarily increasing its enterprise value; which on the surface seems counter intuitive.  If increasing the value of the business for shareholders is the ultimate goal, then all earnings growth is not good growth.

So how can business value stall despite demonstrated earnings growth?  The simple answer is that the incremental earnings were not enough to cover all the operating costs plus the cost of capital (including the opportunity cost of the equity in the business).  Every business owner/manager should know what their "weighted average cost of capital" is (or WACC), in order to manage its capital judiciously. Simply growing your operating profit without considering the full cost of both the fixed and working capital will not necessarily build value into your business.

Some examples of value enhancing management strategies are given below.

1) Increase profits without tying up any more capital.  This can be in the form of improving margins and/or lowering operating costs or both, if the total capital does not increase. 
2) Decrease capital without losing earnings.  Some possible options include:
            - Lowering inventory levels or increasing inventory turns
            - Shortening selling terms or improving collection practices
            - Negotiating better supplier terms or take advantage of supplier incentives
            - Divest redundant assets

3) Divest, liquidate, or discontinue parts of the business, where the lost earnings are more than offset by the savings in the cost of capital.
4) Only invest (increase capital) in projects that provide a return that exceeds the cost of capital.
5) Reorganize the capital structure of the business to lower the overall cost of capital.

While topline and profit growth are essential elements of increasing enterprise value, profit growth needs to be disciplined and it must always exceed the cost of capital.

The astute reader may realize that I am referring to concepts espoused by practitioners of “Economic Value Add” or “EVA“: a profit metric that is netted against a charge for the WACC.  A business that focuses on increasing EVA over the long-term, becomes meticulous at managing the capital entrusted to it by its shareholders.

Other astute readers may be thinking that it is the market that ultimately determines the value of any business.  For private businesses, that typically means it can only be determined when the business takes in new investors, or when it is put on the market to be sold.  Of course, there are many factors that determine the value of any business, but remember, disciplined profit growth is typically rewarded by attracting more buyers or investors that are willing to pay higher multiples of earnings.

In summary, generating profit growth without considering whether it exceeds the full cost of capital is like driving a car blindfolded – you may be moving but it might be in the wrong direction!

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