3x creating equity value in your company
Kempen supports entrepreneurs and management teams that want to increase the return on equity of their company. The first time many business owners start to think about this metric, is when they contemplate a potential sale of their company and realize return on equity is a key valuation driver. We help them navigate a simple framework to increase equity returns.
There are six sources to increase the return on equity of a company: 1) Increase revenue, 2) Increase profit margin, 3) Increase debt, 4) Reduce the cost of debt, 5) Lower taxes, 6) Reduce the capital employed in the company.As source 1 and 2 are mostly driven by the business, we would like to focus on the more financial and structuring sources in this article. The potential impact of debt, taxes and capital employed (sources 3 till 6) are described below:
For many of our clients a very restraint approach towards leverage works well. However, too often we see that an entrepreneur sells his company, just to find out that the buyer realizes a return by attracting debt and paying it off over time. Obviously this return can also be captured without selling the company: by refinancing the company and putting the proceeds to work or distributing them. The below example indicates the impact of applying 2.5x EBIT leverage on equity returns.
The lower the interest on debt is, the more the effect of leverage benefits return on equity. Considering the interest development of the last view years, a refinancing of debt can be an attractive source for increasing return on equity. The example below shows the additional impact of a reduction in interest rates on return on equity.
With a likely change in the future Dutch corporate tax rate, we observe that putting some thinking into 1) the timing of realizing profits and losses and 2) the value of deferred tax assets & liabilities, can create significant value. Below an example of the impact the expected reduction of the Dutch corporate tax rate from 25% to 21% has on equity returns.
3. Capital employed
Thorough analysis of the assets and business activities that consume capital within a company often reveals opportunities for improvement. Financial-, and peer analysis provide helpful insights where a company should or should not allocate capital. Common items for improvement are working capital and non-core assets, but sometimes more strategic analysis points to a better use of capital in the future by divesting whole business units. In the example below we show what the impact of reducing the capital employed can be on equity returns.
Although the above examples are an extreme simplification of reality, it is our experience that often a few relatively simple steps can create a much more attractive return on equity. When we for example combine the four simple steps used as examples, return on equity increases from 10% to 20%.
The 20% in the above example approaches the returns private equity investors typically try to achieve. With Kempen we would be happy to provide some ideas how to achieve those type of equity returns at your company in the coming year.
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This article was originally posted on LinkedIn.