The language of finance – procurement and PE ratios

Thanks for all the comments  on our “speaking the language of finance” post recently – do read them here. I do agree of course that we need to speak the appropriate language, whether it is IT, Marketing or whoever we’re dealing with. But Finance seems to be the one consistent element for pretty much every procurement person, hence our focus on it here. But we’ll certainly come back to issues around stakeholders in those other areas.

So let’s start on finance with something pretty fundamental to private sector organisations – company valuation and PE ratios*.

Now, like anything else that is bought and sold, an organisation is “worth” what someone is prepared to pay for it. And if we’re valuing a company on that basis, we run into an immediate problem – it is very difficult to know just what that figure might be. For instance, the SAP purchase of Ariba last year was arguably hard to justify on conventional measures that we’ll describe below  – but the value to SAP lay in the future opportunity it gives them to develop the supplier network business, a strong brand name and client base, software that complemented SAP’s own portfolio and so on.

Such factors are not something that procurement can influence strongly. So we are probably better focusing on the more conventional company valuation methods, linked to earnings or profit.

Three different approaches are  commonly used in business valuation: the income approach, the asset-based approach, and the market approach (which is the SAP / Ariba example we discussed above).  Now the asset based approach is simply a valuation of the assets of the business, from the bottom up. However, that may include intangibles such as brand value, as well as cash, property, machinery and stock, so it is not always as straightforward as it sounds.

The income approach is probably the dominant methodology, and this is where it gets interesting for procurement people. This method looks at the future income stream the owner of the business might receive from it. So that includes the future flow of profit, which could be paid out to the owner, and perhaps a value from selling the organisation sometime in the future (if that is required or desired ).

The key valuation parameters are therefore principally sales / revenue, (the “top line”), which often gives an indication of current and future growth,   and earnings / profit / income (“the bottom line”) in its different guises.  But what can appear confusing is the very different valuation that investors can put on two businesses with similar sales or profit. That is in the main down to the growth prospects for the firm.

If a business is expected to grow and profits increase, then the net present value of the future income stream will be much higher than for a business with flat or declining  sales and profits – and that present value of earnings is a reasonable  way of valuing a business.

For example, which of these net income streams would you choose if you were offered one or the other?

Year 1

2

3

4

5

Business A

£10

£10.50

£11.025

£11.58

£12.16

Business B

£8

£12

£18

£27

£40.50

Now even though you will discount the future earnings (money in five years time has less value to you than money today), Business B probably looks like the better bet, even though income in year one is less. That’s because the income grows at 50% a year, whereas for Business A it is just 5% a year.  So the valuation of Business B will be higher than that of Business A, despite its “profit” this year being lower.

That is reflected in a vital valuation measure - the PE or price-earnings ratio.  This is an equity valuation measure defined as market price per share divided by annual earnings per share – or the ratio of total market capital value over earnings. So in simple terms – “how many times the net income is the company worth?”

Hence Business A might be valued at £100 – ten times its current net income – which would be a PE of 10.  Business B might be valued at £400, because of its much faster growth rate and therefore future income stream. That would give a current PE of 50.

So one key point for procurement is that the market allocates a value to firms based on a multiple of their profit – so if procurement can contribute to this, our effect can be many times the actual savings. If your firm is trading on a PE of 15, a £1M procurement saving can increase the business valuation by £15M!

However, there is a catch. Because the valuation is around the future income stream, the “savings” really need to be sustainable rather than one-off. A single-year profit improvement has some value, but if it disappears again next year, it has limited effect on the valuation (hence firms with big profit swings up and down tend to have lower PEs than those showing steady growth).

So sustainable, step change improvement in the cost base via procurement actions are very desirable – and you can then fairly claim that “procurement has increased the value of the organisation by X million £, $ or Euros”

 

* Obviously, this doesn’t apply in the public sector, so you may want to pass on this – but if you have any thoughts that you might one day want to work in the private sector, being able to demonstrate understanding in areas such as this could be very useful at interview!

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