Valuing a business is a detailed and nuanced process. You need to consider multiples, DCF, and the competitive landscape — and that’s just to get you started. With so many dynamic factors at play, it can be extremely challenging to identify the exact worth of the business. But, in most cases, you can get a reasonable number.
With the recent valuations of Zynga, Groupon and Facebook, it seems like the numbers have been unusually high. Each announced valuation was received as a bit of a surprise. Despite intense media attention and underperformance of these businesses, high valuations have continued — just look at the $3.25 billion valuation of Square last month and the valuation will probably grow as PE dry powder could continue to push valuations higher.
The audacious numbers have sparked our interest in learning more about what factors contribute to a high valuation. Rather than examining the tech industry — which has been known to encounter a bubble or two — we decided to speak with David Rudofsky, a leading strategic expert for mid-sized food businesses, a more grounded industry.
Rudofsky is the current president of Rudofsky Associates, having previously served as Director of Strategic Planning for Altria and Cost Manager for Kraft Food. According to Rudofsky, there are five characteristics that should signal a higher valuation: long-term product differentiation, forecasted purchasing capabilities, cost reduction know-how, distribution channel management, and international presence.
1) Product Differentiation:
One of the most important considerations when valuing a food company is its ability to distinguish itself from its competitors. Although this trait is valuable in any industry, it is particularly important in the food business. Rudofsky explained, “The barriers to entry are relatively low in the food business, making it especially important for brands to establish a meaningful point of differentiation from their competitors. Companies which have established this differentiation are inherently more valuable since they are better able to achieve premium pricing for their brands, while also reducing vulnerability from me-too competitive entries.”
However, Rudofsky warned against overvaluing temporary competitive advantages. He explained that product differentiation is only truly valuable when the brand can withstand new market entrants. “A sustainable competitive advantage is one that is reinforced with either patent/trademark protection or has become recognized as a leader of a category. In this position, it is hard to undermine the market presence of these companies. Temporary competitive advantages have none of these guarantees and can quickly lose their value.”
2) Purchasing Capabilities:
Another characteristic that adds to the value of a company is its ability to appropriately forecast and purchase its goods in bulk. “Food manufacturers invariably have a natural long position in one food commodity or another — be it grain, dairy, meat, vegetables, etc. Manufacturers that are able to source advantageously and/or establish appropriate hedging programs should be able to obtain higher gross margins and be less susceptible to commodity squeezes.”
Rudofsky added that centralized purchasing can also help reduce packaging costs. “Although hedging on commodities is important, knowing specific purchase quantities can help a company prepare packaging materials. By providing suppliers with this information, the supplier can be more efficient and can pass the savings onto the firm.”
Like any valuable asset, the creation of this type of system can be challenging. Rudofsky remembered issues with centralized spending at Kraft Food, “Even at Kraft, which had a strong centralized purchasing operation, there was the occasional issue with decentralized spending — we called it ‘maverick spending’. If it can happen in a company that size, it is bound to happen in smaller ones. For a $10 million company, there is barely enough budget for a purchasing resource, let alone an entire department.”
3) Cost Reduction Know-How:
In addition to managing costs through forecasting and hedging, a company’s ability to identify techniques that can help mitigate costs will make it inherently more valuable. “Manufacturers with cost reduction capabilities deserve a higher valuation because they have the in-house capability to continue growing earnings even when sales volume plateaus. Combine good internal process engineering and R&D professionals with a strong cost accounting capability, and you have all the elements needed to maintain a first-rate cost reduction program.”
As an example, Rudofsky told us about a client from several years ago. He explained, “They suspected that one of their products was slowing their earnings. However, they had no real numbers to evaluate. When they finally tested it, they learned that one product had 25% gross margins, while the other had 45%. They made a change of supervisor to the underperforming product and quickly realized a 25% increase in gross margins.”
Rudofsky continued, “Sometimes, a cost reduction strategy is simply being able to identify certain products that should be removed from the portfolio entirely — certain products can often just be weeded out. They can be pulling all financials down, especially for a business that is close to capacity.”
4) Channel Management:
According to Rudofsky, the fourth characteristic that should be considered when valuing a company is the state of its distribution channels — identifying the appropriate channel is vital to the success of a food business. As Rudofsky explained, “Distribution channels for food products have proliferated tremendously in the last twenty years. Each channel requires a unique distributor — the distributor who gets you into Whole Foods is not the same one who is going to get you into a Duane Reade or CVS.”
Since the channels are so distinct, the ability to sell down a variety of channels is extremely important. Rudofsky continued, “The manufacturer with the experience of profitably selling down a variety of channels should be seen as more valuable.They have more diversity in revenue options and expansion options, making them capable to more quickly and profitability grow their early stage brands. However, not all channels are good for all products. Companies should figure out which of their products can go down which of the channels.”
5) International Presence:
The final factor to consider when valuing a company is its international presence. A global presence has the clear advantage of enabling rapid brand development. Rudofsky explained, “The largest food companies typically have at least some international presence. Multinational giants such as Unilever, Nestle, and Kraft Food have the capability to take basic brands and food concepts from their established market and introduce them in developing countries, while also sourcing exciting new ethnic food products from those countries and introducing them into more established markets.” He continued, “Many mid-sized food companies are exclusively based in the US. If a mid-sized company has an international presence, it should be valued at a higher multiple because it has the ability to grow brands more quickly across international borders.”
However, another benefit to international presence is its ability to create distribution partnerships. “The international distribution channels, product aside, makes a company more valuable. Many smaller firms may approach it, looking to partner with the firm and have their products shipped overseas. These partnerships can be a valuable source of revenue.” Rudofsky continued, “I have a client that has a presence in Russia and the Middle East. I have already been able to approach them with smaller companies that are looking to piggyback on their distribution channels. They have an incredibly sophisticated system in place.”
Although Rudofsky’s examples may be unique to the food industry, the advice holds in most industries. Regardless of the specific business, a company that is able to secure a market position, strategically purchase goods, consistently identify cost-cutting strategies, and have a diversity of international distribution channels will be in a strong position to grow and develop. It’s valuation should be higher to reflect these strengths. How much higher is up for debate — just look at Facebook, Zynga, and Groupon.