As I saw in my former life as a Goldman Sachs partner, setting the initial price range for an upcoming IPO or negotiating the value of a merger involved a combination of science and art. The basic formula driving any company’s valuation is the product of some nearer-term financial measure like earnings per share times “the multiple”. But given a lack of quality data to predict the multiple, the value of a company often varied by hundreds of millions or billions of dollars based on limited information.
However, I believe “the multiple” is due for an extreme makeover. The multiple (or terminal value in a merger) is driven by the estimated longer-term growth rate of the core financial metric used in a particular industry. In practice, this often comes down to an estimate of future sales growth because the top line tends to drive the bottom line over time. Sales growth in turn is a function of retaining existing customers and acquiring new ones, with the former being more profitable than the latter. This is where we are seeing an emerging predictive breakthrough.
In a mobile versus word of mouth world, it is increasingly hard to recruit new customers when existing ones are unhappy. There has been an age-old discussion about whether it is more productive trying to recruit new customers or retain existing ones. That debate is rapidly being settled in favor of retention because existing customers are the key to recruiting new ones as the collective wisdom of the crowd becomes more transparent.
“Today’s digital era makes assessing customer outcomes increasingly possible for those companies and investors that learn how to listen at scale and organize their decision-making accordingly.”
So we can simplify and now predict the right multiple by zeroing in on existing customer outcomes. Today’s digital era makes assessing customer outcomes increasingly possible for those companies and investors that learn how to listen at scale and organize their decision-making accordingly. This doesn’t mean using big data to predict next quarter’s results sooner, but rather a more fundamental understanding of a company’s longer-term customer and employee value propositions, related strategies and potential competitive moats.
In 2012, I founded a technology company based on a simple observation: Companies that connected with their customers and built a great team almost always won. What we have since learned is that there are two primary predictors of future revenue growth and the right multiple: 1) What are the customer/employee outcomes and 2) How committed is management to listening and acting upon them?
One fascinating by-product of this shift in valuation methodology is that it should curb some of the short-term quarter-to-quarter pressure and provide a defense against activist shareholders when a company is doing the right long-term things at the expense of current earnings.
We are at the beginning of a once-in-a-generation change in the way companies are valued. The right multiple will become understood by observable customer and employee outcomes. This creates an opportunity for innovative leaders and investors who develop listening skills and get there first.