Thursday, 14 February 2008

Size really does matter

What makes one company relatively 'worth' more than another? I guess that is one of the questions I have been asked most often in my life as an analyst.

THE most important valuation metric is the company's potential organic growth rate. Even historic performance is less important in comparison. You could have doubled in size in the last year but if the perception is that you have run out of growth, your valuation will be severely damaged. Perhaps the record of Google's valuation compared with Microsoft is the classic example of this. At one point only five years ago Google was worth several hundreds times its revenues whereas Microsoft has seemed stuck at 4-5x revenues for years. Even now Google is worth 10x next year's forecast revenues.

Of course, what effects your potential growth most is the market segment you address and what you offer to it. 'Commodity' players like PC dealers or ITSAs have lower valuation metrics compared to, say, software products companies owning their own IPR.

After organic growth, it seems that size really does matter. The chart below from M&A specialists Regent (where I serve as a NED) analyses European tech. acquisitions in 2007. Whether you choose P/E or PSR as your choosen metric, the analysis really does show that size matters! The chart shows that a company with revenues of less than $1m might be valued with a PSR of around 0.5 whereas a company with revenues >$1b might be worth upto 3.5x revenues. In other words almost seven times more! Pretty similar metrics applies to P/Es.

A word of warning though. You should look at these statistics with some care. They cover all types of company. There tend to be more 'commodity' companies at the smaller end. An analysis of valuations of companies of the same type would also show increase by size; but the difference would not be quite so pronounced.

One obvious conclusion from this is that, in a static market, it really could pay you to 'bulk up'. You really can boost shareholder value by substantially increasing your size.

Mind you that doesn't change Holway's views about the consolidators. Consolidation is fine when companies stick to their core competences. But even here companies have to contend with the dreaded 'Acquisition Indigestion'. It also rarely works where companies move into new areas and geographies just for the sake of 'bulking up'.

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