We live in unprecedented times where emerging businesses seem to mint billionaires on a regular basis. One would have to look to the Gilded age over a century ago to find a period so characterized by capital formation, entrepreneurship and business wealth creation. In 1980, there were scarcely ten billionaires in the United States. By 1987, that number has risen fourfold to nearly fifty and was accelerating. By 2020, the number of American billionaires had risen to over 900. Collectively, this exclusive group controlled an estimated $3.7 trillion in assets, or roughly the equivalent of annual gross domestic product of Germany, the world’s fourth largest economy. Nearly 60% of the members of this group are self-made, and nearly all the fortunes in this group emanate from businesses boasting potent business models that have contributed meaningfully to overall economic prosperity.
At a basic level, business formation is a vehicle for personal employment, offering corporate founders the opportunity to serve as their own boss. The performance of most companies does not rise to a level that enables them to be worth materially more than they cost to put in place. Yet, the entrepreneurs who take the risk to start these enterprises can often earn a solid living, with the chance to put away sufficient savings into other investments that can eventually lead to personal wealth.
Wealth creation is different. To create wealth entails being an active business owner or investor, getting your hands dirty and devising a means of making your company worth more than the cost of its parts. Wealth creation is the purview of active business investments and can give the appearance that money is being minted from thin air.
The simple recipe for making a business worth more than it cost is to deliver returns that exceed investor requirements. In business, it is the excess return, and not the appreciation of underlying business assets, which creates value from thin air. Nearly all the world’s 3,200 billionaires made their money this way, founding companies endowed with some of the finest business models going and often creating multiple members of this exclusive club.
For the rest of us, the good news is that the capital formation that gave rise to such businesses is broadly available. More importantly, the bar for value-creating business models is much lower than that realized by the world’s billionaire unicorns. Businesses do not need to solve enormous problems, address global markets, have limitless scalability or high levels of operating leverage to create meaningful wealth.
Given that investor returns lie at the center of wealth creation, the initial question is, “How are returns calculated?” It turns out that business models can be broken down to as few as six financial variables that work cooperatively to deliver investor returns. Those essential ingredients include the following:
- Business Investment
- Operating Profit Margin
- % of Business Investment Funded with OPM
- Cost of OPM
Apart from sales, the definitions of each variable are not self-explanatory. They also do not tie out to accounting numbers, since the formula is based on universal financial concepts. For instance, Business Investment excludes all non-cash accounting conventions, but includes working capital. The latter means that all non-interest costing unsecured working capital liabilities comprise a deduction from business investment, while their working capital asset counterparts are included in business investment.
The amount and annual cost of interest-costing liabilities are two other variables. I refer to interest costing proceeds from lenders, individuals or institutions is referred to as OPM, which is short for “Other People’s Money”. The reason for this verbal simplification is that interest-costing money does not just come from lenders, but also from the lessors of equipment and real estate, whose proceeds are integral to corporate capital stacks.
Operating profit margin also excludes all non-cash accounting terms like depreciation, amortization and stock-based compensation. It should ideally also exclude rents on property that is leased but could otherwise have been owned. Since the associated lease proceeds are a part of OPM, the payments for them (like OPM interest expense) should be omitted from operating profit, meaning that operating profit is essentially earnings before interest, taxes, depreciation and rents on property that might have been owned, or EBITDAR, as a percentage of sales.
Finally, maintenance CapEx includes the cost of capital investments to annually maintain physical assets, plus the costs of sporadic remodeling to maintain competitiveness, plus any losses associated with occasional physical asset investment mistakes. This variable can be further expanded to include research and development costs and can also even include allowances for occasional M&A investment mistakes for acquisitive companies.
The Value Equation
Once defined, our six variables can compute a current pre-tax equity return. The Value Equation is simple and works like this:
This equation is important to know, because it rests at the center of expected total investor rates of return, drives business wealth creation. Going from a current pre- and after-tax rates of equity return (ROE) to estimate wealth creation can be done in six steps:
1 Base expected total rate of return.
At a stand-alone business level, assuming all your current pre-tax ROE is paid out to investors, the expected total rate of investor return will equate to the current return plus an annual expected growth rate.
2 Sustainable Growth Rate.
The current after-tax ROE also approximates the maximum sustainable growth rate. That is the among of growth your company can realize without new equity infusions. So, should you reinvest all your after tax cash flow into corporate growth with all the equation variables to unchanged, sales could be expected to grow at a rate equivalent to the current after tax ROE.
3 Potential total rate of return with compounding.
With your after-tax returns not distributed, but fully reinvested into growth, the cash flow growth rate can likewise be expected to rise by the current after-tax ROE. The impact of cash flow compounding transforms the base investment into one having materially higher growth and total expected investment return.
4 Equity Valuation Multiple.
Given the perceived risks inherent in your business, the current equity returns and the prospects for equity return growth achievable through compounding, outside investors can determine the returns they would require to make a similar investment. Just divide your current pre-tax rate of return by the return that would be required by outside shareholders to arrive at your equity valuation multiple.
5 Equity and Total Business Value.
Multiplying the equity invested in your company at cost (this includes equity issued as well as your reinvested cash flows) by the equity valuation multiple will compute equity value. Add that to the proceeds from OPM and you arrive at total business value.
6 Equity Market Value Added.
Finally, the equity valuation multiple – 1 will equate to an equity market value added (EMVA) multiple. EMVA is the amount by which equity is worth more than it cost, which is what business wealth creation is all about. Just multiply the cost of your equity by the EMVA multiple to arrive at your EMVA, which is at the heart of the personal net worths of most highly successful entrepreneurs, business leaders and investors.
Corporate Success Hallmarks
The six Value Equation variables are universal. What’s not universal are the business and operational models that comprise them.
Business models can vary, but only so much. Here, the most impactful elements are embodied within the first three business model variables and the level of anticipated organic growth. Other variables also come into play, such as operating leverage, or the amount by which business investment rises as sales grow. Likewise, there may be economies of scale, which can elevate your operating profit margin. Revenue growth can have an impact on your Value Equation variables, often for the better.
Operational models are another matter and entail creativity, accompanied by a myriad of decisions. I know this personally from leading three similar and sequential publicly traded companies, two of which I co-founded. The latter companies saw their six value equation variables benefit from many changes in our operating models, some large and many not so large.
Whatever your sales volumes, margins, business investment requirements or base organic business growth potential, the Value Equation can serve as your performance report card. It is your guide to EMVA creation, which I and our teams over the years have focused on as public company leaders and stewards of investor capital. Businesses that don’t just deliver earnings, but create wealth, stand apart. In such performance rests wealth creation that delivers personal, stakeholder and community benefits that are the hallmarks of corporate success.
About the Author
Christopher Volk, author of THE VALUE EQUATION, has been instrumental in leading and publicly listing three successful companies, two of which he co-founded. The most recent is STORE Capital (NYSE: “STOR”) where he served as founding chief executive officer and then as executive chairman. Volk, who has written about corporate finance since early in his career and has created an award-winning video series about the topic, is a regional winner of EYs’ Entrepreneur of the Year award. He resides in Paradise Valley, Arizona, and Huntsville, Alabama.