Chris Mercer (founder of Mercer Capital) wrote THIS article originally back in the 1990s. It’s a concept that he carried over into the numerous editions (now three) of his book, The Integrated Theory of Valuation (which I highly recommend and you can purchase HERE). He introduced the concept of the GRAPES of value, which I think is an excellent way to simplify the key components what drives the value of any business. So, in this article let’s explore the concepts and how they relate to an exit planning scenario.
First, let’s breakdown the acronym. The GRAPES of value stands for:
I’ll discuss each one below.
In general, companies that are growing cash flow are attractive. The rate of long-term sustainable growth will have a key impact on the valuation of any business. Note that I used the word ‘sustainable’ which implies that a company can continue growing into the foreseeable future rather than implementing flash in the pan strategies that will result in a one-time bump in revenue or cash flow. Growth must be viewed through a long-term lens. While companies can grow at 50%+ year to year in the short term, over a long-term horizon. The key question is whether a company will simply grow at the overall rate of the economy or a slightly faster rate. The industry in which a company resides also plays an important role. For example, a company operating in a growing industry has a better chance at above-normal growth over the long term than one operating in a sunset industry. Growth is best examined over a period of time, which is often why a discounted cash flow analysis (which uses multiple periods of time rather than just simply one) is more equipped to capture the true value of a business.
The second critical component of valuation is risk. A prospective buyer is not buying a guaranteed stream of cash flows like they would if buying a US government bond (the closest thing to a risk-free investment in the world today). For any business, there is always risk that the cash flows that exist today will not materialize tomorrow. This is why due diligence is performed and financial information is forecasted for a business when acquisitions happen. Buyers are trying to assess the risk of the business achieving certain cash flows. This risk factor is referred to as the discount rate. (Note that a capitalization rate is slightly different and incorporates both a risk and growth factor.)
Investments do not exist in vacuum. Rather, every investor will compare the expected return on their investment relative to the risk of that specific investment and relative to the risk of alternative investments. For example, a US government bond is considered the least risk investment one can make. Thus, the interest rate on such an investment is often referred to as the “risk free rate” since it serves as the baseline for all investment risk in the world. That is, there is no other major investment vehicle out there that is less risky, thus all expected returns must be based off this benchmark. Beyond that, investors will also compare returns on other investment vehicles such as stocks, bonds, real estate, other alternative investing classes, as well as other similar companies. The expected return of an investment in a business needs to be commensurate with its risk and expected growth, otherwise, a prudent investor will move onto other investments that better fit those criteria.
While the valuation of a business is often heavily correlated with the level of expected future cash flows, to understand the true value of those benefit streams today, we need apply a present value to them to account for the time value of money. Whether the valuation employs a single-period or multi-period approach, the benefit streams represent future cash flows that require the time value of money to be considered when assessing results today. A good reason why this is important can be explained through an example where a business forecasts its growth over the next ten years. It predicts little to no growth in years 1-5, followed by double-digit growth in years 6-10. While that predicted growth is nice, the further away from the present that growth in cash flows take place, the less valuable it is to an investor today. In contrast, the company that is expected to grow cash flows in the next few years then experience a leveled off growth might be more valuable today. Wimpy had it right when he said, “I’d gladly pay you Tuesday for a hamburger today.”
One critical aspect in valuation is the concept that the valuation of a business must be based on the expected future cash flows (or in some cases, the asset values) of the business. While the past may be a guide to what the business will do in the future, a business valuation always reflects future expectations. A business that was rolling along pre-pandemic that is now expected to be permanently impaired on a going forward basis is not going to be worth as much today as if the valuation had been performed on a pre-pandemic basis. Similarly, a business that has been cash flow negative for years but is expected to finally make a breakthrough and become very profitable in the next year can have a high valuation. The reality is a prudent investor does not care about what has happened in the past, they only care about what is likely to transpire in the future.
Any business valuation must be based on rational principles that a prudent businessperson would consider. That can even include valuation premiums for synergies. However, it is important to separate the concepts of value and price. Warren Buffet (based on studying the work of Benjamin Graham, the grandfather of value investing) originated the saying “price is what you pay, value is what you get.” From this saying, we can infer that price for a business is a more fluid concept than the value of a business since price can be impacted by various factors including emotion, individual perspective, negotiating experience, and leverage. In contrast, while value can certainly be subjective in nature, it is based more on sound principles that have stood the test of time.
How Does All This Apply to Exit Planning?
It is important for business owners to understand the above concepts when starting a value creation and exit planning program. One of the key starting points for business owners to understand is that they do have some control over the valuation of their business; they are not merely victims of a fickle and uncaring marketplace. Below are some bullet points which outline how the value concepts we discussed above would be relevant to an exit planning scenario.
- How is the business going to grow before an eventual exit? How does this compare to the rest of industry? Most importantly, how is growth going to be achieved? Nothing in life is free including growth. You should understand specifically how that growth is going to be achieved through a prioritized action plan. Additionally, it should be focused on sustainable growth, not growth achieved on a one-time basis or through financial engineering.
- Owners looking to grow and exit their business should accurately assess what is referred to as “company specific risk”. Increasing the value of your business can be achieved through growth and de-risking the business. While de-risking the business is less exciting than growth initiatives, it is a critical component of value creation. Once owners have assessed areas of weakness such as systems and processes or customer concentration, an action plan can be drawn up to slowly reduce risk over time. Lastly, it is important to understand that weaknesses will be identified during the due diligence process and if the prospective buyer perceives too many red flags, the end result will be a significant reduction in the purchase price or even perhaps the prospective buyer walking away from the deal altogether.
- It is always important to remember that any prospective purchaser of a business will assess the value of your business based on the relative risks and rewards of the expected future versus other alternatives. For example, a hypothetical purchaser may be attracted to the prospects of integrating your intellectual property and human expertise into their existing operations, something that may be less expensive and time consuming than developing that expertise organically. In other cases, prospective buyers may have any number of criteria they are looking for in a viable business and the one that “checks the most boxes” may win the day if the price is reasonable.
- For most Middle Market businesses, if you are truly interested in understanding your value, using a multi-period approach (used in a discounted cash flow analysis) is highly recommended. First, this creates a more accurate valuation, especially when growth rates are expected to vary over the course of time. Second, creating a multi-year forecast is a good discipline when undertaking an exit planning project because it forces you to commit to paper what you want to achieve and accordingly, you must understand how you will achieve it. The more you have control over this process, the more control you will have over increasing the value of your business.
- Lastly, all owners must understand the differences between price and value. Through undertaking a holistic value acceleration project, the underlying value of the business will grow, thus increasing the chances that price and value will intersect when it is time to transition the business. This often entails the owner separating themselves from the business (both emotionally and in a literal operational sense).
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