Your Business Is Growing. Is It Becoming More Valuable?

More sales can be good news. They don’t establish that your business is becoming more valuable. You also need to understand the capital the growth requires, the cash it could produce and the risks and capabilities that come with it.

Consider a fictional business owner having a record sales year.

The company has more orders, more employees and a bigger building. From the outside, it looks like success.

Inside, the owner is approving more exceptions, settling more disputes and putting off time away. A supervisor who used to run one team is now responsible for three. An important customer expects an answer that only the owner can give.

The company has become bigger.

Has it become better able to create value?

That question deserves its own examination.

Revenue measures one part of the business

Revenue tells you about sales. It doesn’t tell you everything the company had to commit to make those sales possible.

Growth may require equipment, inventory, hiring, training or additional cash while customers take time to pay. Profit can rise without an equivalent increase in cash available to the owners.

That isn’t automatically a problem. Reinvestment can be worthwhile. A temporary cash squeeze can accompany a sound expansion.

The question is what the investment is expected to produce, when it could produce it and how much uncertainty comes with that expectation.

In valuation, growth needs to be connected to reinvestment and the returns it can earn. The finance principle is that new investment creates value when its expected returns exceed the return required for its risk. Faster growth alone doesn’t settle that comparison.

What did the extra work expose?

Return to the fictional company.

The owner may have approved an expansion that makes economic sense. But the business also needs the capabilities to deliver it.

If employees cannot resolve ordinary problems without the owner, adding more work can add more decisions to the owner’s desk.

If the management team hasn’t developed alongside the operation, another department can stretch the same people further.

If one customer already has disproportionate influence over the business, accepting more of that customer’s work can deepen the dependence.

None of those observations tells us the expansion was wrong. They tell us what needs investigation.

The owner may need a different management arrangement, better pricing decisions, stronger customer relationships, additional capacity—or a different sequence of improvements.

More selling won’t answer those questions by itself.

A larger business can still depend on the same person

An owner can build a substantial company while keeping critical judgment and relationships concentrated personally. More work can then increase the load on the same person rather than strengthen the team’s ability to carry responsibility.

If the owner wants to change their role, ask what the team can now handle and what still depends on that owner. More revenue doesn’t establish that the business has become more transferable—or easier to own.

Look for evidence of what improved

A busy year gives you activity to examine. It doesn’t provide every answer.

Alongside your sales figures, ask:

• What additional capital did this growth require?

• What cash could it produce after the reinvestment the business needs?

• Which capabilities became stronger, and what demonstrates that?

• Which dependencies or constraints became more significant?

• What can the team now handle that previously required the owner?

• Are the expected benefits sufficient for the resources committed and the risks involved?

The answers need context. A number that is useful for one decision may be inadequate for another.

Revenue, accounting profit and EBITDA can each contribute information. None supplies a complete diagnosis or valuation on its own.

Decide what kind of growth you want

The purpose of this examination is to make better choices about growth.

You might find that the current expansion deserves more investment. You might find a capability that needs to be developed before the next step. You might discover that an apparently attractive opportunity would consume resources needed for something more important.

That is why diagnosis and sequencing matter.

Before asking how to make the business bigger, ask what needs to become more capable—and how that improvement could create value.

If your business is growing but you aren’t sure what is improving for you as an owner, that is a useful place to begin a conversation.

Further reading: Aswath Damodaran on growth, reinvestment and value, November 30, 2016.

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