In his post,  Can You Change Everything? , Seth Godin considers the possibility that “You might not be as permanently stuck in a rut as you think.”   After skipping past ones like “become a vegan”, I excerpted my favorites from Seth’s 45 item list of possible rut-busters:

3.    Publish your best work for free online
4.    Close your worst-performing locations
8.    Host a conference for your competitors
9.    Connect your best customers and organize a tribe
10.  Fire the 80% of your customers that account for 20% of your sales
11.   Start a blog
12.   Start a digital bootstrap business on the weekends
14.  Go on tour and visit your best customers in person
15.  Answer the customer service line for a day
16.  Learn to be a killer presenter
18.  Delete your website and start over with the simplest possible site
19.  Call former employees and ask for advice
22.  Sell your cash cow division to the competition and invest everything in the new thing
24.  Become a gadfly and tell the truth about your industry
28.  Have all meetings in a room with no chairs, and everyone wears a bathrobe over their clothes
31.  Find every project that is near the danger zone (in terms of p&l or deadlines) and cancel it, no appeals
33.  Get an RSS reader and read a lot more blogs
35.  Write five thank you notes every day
42.  Hire a firm to make a documentary about your organization

Zayo-ite’s and Envysion’eers, which ones might be most interesting for your businesses?

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Jim Crowe Logs onto the Internet

I continue with my series of Measuring Value Creation.  My focus is on the equation “Today’s Value = 4Q09 EBITDA Annualized * a defensible multiple.”   My prior post presented simple examples of how to value a company.  Curiously, the valuation had seemingly nothing to do with EBITDA or with a defensible multiple.  Instead, it had only to do with free cash flows and something called a discount rate.  I promised to connect the dots.

Let me start by re-iterating a management principle that is at the core of my business beliefs: the concept of Intrinsic Value:

An enterprise is worth what its free cash flows, appropriately discounted, are really going to be.

There it is again.  To know what a business is worth, all you need to know is free cash flows and how to “appropriately discount” them.  In my examples from the prior post, we valued enterprises as follows:

• A company that will return $1M of free cash flow a year for a long time is worth ~$10M.
• A company that will return $1M of FCF in year one and, in each subsequent year, the cash generated would grow by 5%, is worth ~$15M.
  
• A company that will return $1M of FCF in year one but grow by 10% is worth ~$27M.

In all three examples, I provided 10% as the “appropriate discount rate”.

So why do I veer away from a Net Present Value of Free Cash Flow model for my Measuring Value Creation methodology?  Recall the criteria I set forth for my methodology, with a particular emphasis on #1 and #3:

1. The actions and results that are taking place in the here-and-now are the primary driver of the measurement.  That is, the measurement isn’t driven by a set of assumptions that might or might not happen in the distant future e.g., a rapid hockey-stick growth curve that magically starts a year from now
2. It is simple enough that the management team understands how it works and, further, they understand why it is good measure of their Value Creation performance
3. Likewise, management is able to explain to the employees how the measurement works and further how each employee impacts either positively or negatively the measurement
4. The board/investors agree that the methodology appropriately captures the Value Creation performance of the business

A methodology that focuses on calculating free cash flows many years from now will be detached from the “actions and results that are taking place in the here-and-now“.   Similarly, the methodology will make it near-impossible for “each employee impacts either positively or negatively the measurement“.

The starting point for any valuation analysis is the initial state of the business.  What is today’s revenue?  Today’s EBITDA?  Today’s Free Cash Flow?   My methodology points to 3-quarters from now as the appropriate definition of “today”.  If forecasting is accurate–which it should be in a well-run recurring revenue business!–three quarters from now is an appropriate indication of today’s performance.    Employees are capable of understanding how their actions and results in the here-and-now will positively or negatively impact the company’s quarterly results in three quarters.

“EBITDA times Multiple” is a short-hand for translating the company’s financial performance into Intrinsic Value.   In the next couple posts, I will address “why EBITDA is used in the shorthand calculation” and “What goes into selecting the right multiple”.

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Criteria for Measuring “Today’s Value”
Measuring Value Creation
Asset Value, Intrinsic Value and the Balance Sheet
Measuring Value Creation Series Wrap Up
Why not Multiple of Free Cash Flow?

Step 4 of my Value Creation methodology is:

Today’s Value = 4Q09 EBITDA Annualized * a defensible multiple.

If you desire to be a successful business leader, it is extremely important to focus on the word defensible. Multiples are a shorthand for a NPV calculation of free cash flows.   This will take a few posts to explain–the first of which was last week’s How much is my Business Worth?.   Let’s say you’re pretty confident a company will return $1M of free cash flow a year for a long time. What is it worth today? At a 10% discount rate, the value of the company would be about $10M.

But let’s add a wrinkle. What if the company is expected to generate cash flow of $1M during the first year. However, in each subsequent year, the cash generated would grow by 5%. In year 2, $1.05M would be generated. In year 10 $1.55M is being returned. Clearly, the annual growth in cash flow makes the value of the company higher. If you did the NPV calculation with a 10% discount rate, a company delivering $1M of cash flow and growing 5% a year is worth ~$20M. This is double the value of a $1M company that isn’t growing.

If the growth were 7.5%, the value of the company would be ~$40M. This is quadruple the no-growth and double the 5% growth.    Clearly, the expected rate of growth is an important variable.

Notice in both this post and the prior one, I did not tell you anything about the revenue of the company. Nor did I tell you about EBITDA. Or capital. Or taxes. I only told you how much free cash flow the company was generating–$1M—and the growth rate of the free cash flow. I also gave a 10% discount rate. If it isn’t obvious, only two variables go into the calculation of what a company is worth. One is the free cash flow it will generate each year. Two, is the “discount” rate.

Ha. Ha.   You busted me.   Neither cash flow nor discount rate is in the formula:   Today’s Value = 4Q09 EBITDA Annualized * a defensible multiple.   I will explain how this shorthand approach is tied to Free Cash Flows and Discount Rate.   And later, I will explain what “discount rate” is all about.

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The last two posts were a continuation of the series on Measuring Valuation Creation.  However, as I re-read them, I realized I probably lost many of the readers.  So I want to step back and recap.

Today is April 30, 2009.   In my methodology, I suggested that the focal point for Measuring Value Creation should be ~4Q09.  Why Three Quarters from Now?

1.  Performance in the current quarter drives financial results “three quarters from now”.  For example, sales performance this quarter leads to installs next quarter which leads to financial statement revenue in 4Q09.  Likewise, value creation projects that are identified and approved in 2Q09 usually help results in 4Q09.   Examples of these are network expense optimization, SG&A savings initiatives, and improvements in service quality.  The last of these three show up in revenue retention and paving the way for improved sales results.   Do a great job this quarter and it will show up in the results 3 quarters from now.

2.  Assuming a well-oiled operational financial process is in place, “three quarters from now” can be forecast with a high degree of accuracy.    Per #1, most of the events that will drive 4Q09 performance have happened already.   I believe a re-forecasting process should be fine tuned such that it captures the forward-looking impacts of current events.  The forecast should not be a “trend-line”–it should be a true bottoms-up reflection of what is happening in the business.   What if you don’t have a robust forecasting process?  First, recognize that this is huge problem–akin to driving at night with your headlights turned off.   Putting in place a robust forecasting process is more important than focusing on calculating value creation.

3.  Financial results in the current quarter reflect the “rear view mirror”. The question many of you might raise is this.    In the value creation equation, why not focus on a multiple of last quarters’ EBITDA?   This is a backward-looking measurement.   Last quarters’ EBITDA is the result of business performance that took place 9 months ago.  Were you targeting the right customers?  How strong were your customer relationships and did you have compelling value proposition?  Did you exceed your sales numbers?   Did you get the revenue installed?  Did the success based capital and the customer driven NetEx come in as planned?  Were network optimization projects identified and acted upon.  Etc. Etc.    Last quarters financials were the result of performance several quarters ago.  They are the rear-view mirror.   A company’s performance today will show up in financials three quarters from now.

In today’s post, I segued (without explaining to readers) to the 4th step of my Value Creation methodology:

4.  Today’s Value = 4Q09 EBITDA Annualized * a defensible multiple.  For example, a defensible multiple for colocation business unit that is growing at 12% a year might be 10X EBITDA

Specifically, I began a build-up to what all is involved with deriving a defensible multiple.   As we get into the next few posts, I will make it extremely clear how important it is to focus on the word defensible. Now, back to the Value Creation series.

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Measuring Value Creation Series Wrap Up
How to Calculate Value Creation
Intrinsic Value’s role in Measuring Value Creation
Why Three Quarters from Now?
Estimating your EBITDA Multiple

Let’s say I offered to pay you $1 for the next 20 years.   What would you pay me for this?

$20? That would be awful generous, considering that I get to enjoy the $20 now and you won’t get to enjoy it for a long time.

$5? Well, that seems chintzy.  I know it takes a long time to accumulate $20, but it would seem like it is worth more than $5.  You know I am good for the $1/year, don’t you?

$8.51? Hmmm.   You explain that you did a Net Present Value calculation, using a 10% interest rate.  You could invest the amount you would give me me and thereby earn interest of at least 5% a year. Though you view I am good for the money, you also recognize 20 years is a long time.  Therefore payments from me seems riskier than putting it in a government bonds.   You settle on 10%–still a low interest rate but given the risk profile, it seems fair.   20 years of $1/year payments at  a 10% interest rate yields a NPV of $8.51.   We both are happy and we shake hands.

Believe it or not, you just learned how to calculate the value of an enterprise.   A business that produces $1M of free cash flow each year is worth about $8.51M.    In this example, I assumed the cash flow occurs for 20 years.  If the enterprise was expected to produce $1M a year forever, the value would be a little higher–~$10M.

The value of the business is $10M.   The annual cash flow is $1M.  The value as a multiple of cash flow is 10X (that is, $10M X $1M).

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$6.25 to $40
3.6X to 23.3X. Urk
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Remember my Finger Nails on the Blackboard post?

Some people get completely irritated by the sound of fingernails scraping blackboards. For others, it is a co-worker in the adjacent cube who constantly taps his fingers. For me, it is sitting through a financial presentation and talking about numbers that are already one and a half months old. I’ve thought about carrying around my own blackboard and scraping my fingernails whenever I am asked to endure this.

Recall the follow-up post No Need for a Rear View Mirror?

“Your rear view mirror is broken,” says your alarmed passenger.

“No worries,” you cleverly reply. “I want to see where I am going, not where I’ve been.”

Most financial reviews focus on the question of “how were actuals compared to budget?” I’m sure we’d all agree that is an appropriate question. The problem is that actual results are usually 30-45 days stale. As an example, I’ll sit in a board meeting in mid-November discussing how we did in September (the most recent month in which actuals were available).

This might not be a problem if you are the Cap’n Crunch product manager for Quaker Oats. I, however, live in the rapidly-changing telecom industry. Wasting time on how we performed two months ago is akin to [driving while fixating your eyes on the rear view mirror].  If that is the best you can do, you are driving at night with your headlights off. It is just a matter of time before your crash.

Telecom is a recurring revenue business.  It is late April, 2009.  At this point, we know what our exit run rate was for 1st quarter.  That is history.  Moreover, we also know what our new sales are for March and April–and what our net installs will be in May and June.  Therefore, we know with a very high degree of precision what 2Q09 will come in at.

We also have a lot of insight into sales, installs, disconnects, network grooms, integration projects, etc. through the next several months.   Thus , we have a very accurate forecast of 3Q09 results. and, though less certain, we are able to make a solid estimate of 4Q09.

Note that 3Q09 and 4Q09 are largely the result of how well we are performing in 2Q09.   That is, a fantastic sales quarter in 2Q09 will lead to great gross installs in 3Q09,  will lead to great financial statement revenue in 4Q09.  Conversely, let’s assume service has degraded in 2Q09.  Perhaps prolonged service activation intervals become prevalent.  Or perhaps network outages lead to credits, disconnects, and slower sales cycles.  The financial impacts will be felt in 3Q09 and 4Q09.

To summarize–Why Three Quarters from Now?

1. Performance in the current quarter drives financial results “three quarters from now”
2. Assuming a well oiled operational financial process is in place, “three quarters from now” can be forecast with a high degree of accuracy
3. Financial results in the current quarter reflect the “rear view mirror”, e.g., how well the company did two quarters ago

Of course, if a company doesn’t have the competency to re-forecast accurately, all bets are off.  The solution is not to change how to calculate value creation, it is to tighten the business processes.

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Recapping.
Measuring Value Creation Series Wrap Up
No Need for a Rear View Mirror
How to Calculate Value Creation
11.6X EBITDA

Yesterday’s post ended with an overnight drum roll.  I promised to succinctly reveal the methodology on how to calculate Value Creation (simple formula). With no further ado, here is the methodology (simple form).

1. Focus on a quarter that is 3 quarters from now.   Now is April, 2009.   Three quarters from now is 4Q09
2. Re-forecast Income Statement, Cash Flow Statement, and Balance Sheet through to the end of three quarters from now (i.e., 4Q09)
3. Amount Invested = Paid-In Capital–Net at the end of end of three quarters from now (i.e., 4Q09)
4. Today’s Value = 4Q09 EBITDA Annualized * a defensible multiple.  For example, a defensible multiple for colocation business unit that is growing at 12% a year might be 10X EBITDA
5. Calculate Value Creation by subtracting Amount Invested from Today’s Value

Yep.  That is all there is to it.  But don’t let the simplicity fool you.  When done  appropriately, this is a powerful and insightful tool.  Obviously, if done sloppily, it is time-consuming but meaningless exercise .

“Cost of Capital” is not taken into account in the simple form of the Valuation Creation formula.  Recall that the full form is Value Creation = Today’s Value less Amount Invested less Opportunity Cost.  I will continue to ignore Opportunity Cost for the next few posts, but I will come back to it later.   For now, I want to emphasize that the simple form is an enormous first step.  This will become clear in the next several posts.

BTW, I warned that you would object to my methodology for one of a dozen reasons.  Was I right?  After you read the next several posts, we will see how many of your objections went away.

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Intrinsic Value’s role in Measuring Value Creation
Measuring Value Creation Series Wrap Up
Recapping.
Opportunity Cost added to Value Creation Forumla
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We are well into my series on Measuring Value Creation.   Remember the formula (in simple form)

Value Creation = Today’s Value less Amount Invested

In the first nine posts, we focused on Amount Invested.    Now we will shift gears completely and focus on Today’s Value.  This will take several posts to explain, but I think it will be well worth it.  As we get into this, I need to emphasize an important point.  My goal is to define a practical methodology for assessing the quarterly performance of a business unit while helping management maximize Value Creation.  To meet this goal, the methodology must pass the following tests:

• The actions and results that are taking place in the here-and-now are the primary driver of the measurement.  That is, the measurement isn’t driven by a set of assumptions that might or might not happen in the distant future e.g., a rapid hockey-stick growth curve that magically starts a year from now
• It is simple enough that management team understands how it works and, further, they understand why it is good measure of their Value Creation performance
• Likewise, management is able to explain to the employees how the measurement works and further how each employee impacts either positively or negatively the measurement
• The board/investors agree that the methodology appropriately captures the Value Creation performance of the business

Let  me emphasize the following.  In telecom, satisfying this criteria is no simple matter.  Telecom is a complex business.   It is capital intensive.  Though absolutely wrong, the conventional wisdom is that most costs are fixed and attempts to associate them to revenue are seen as a futile exercise in arbitrary cost allocation.  Likewise and equally wrong, the conventional wisdom is that most functions should be centralized and this further complicates the association of cost to causer of cost.  Finally, competitive telcom simply has not focused on return on equity invested.

But where there is a will, there is a way.  Deep in my DNA is the belief that the likelihood of creating value is enormously higher if (a) management understands quantitatively how value creation happens and (b) value creation is measured.   In layman’s terms:  (a) Management knows Value Creation when they see it and (b) Management has their eyes open.

Now for the good news and the bad news.  Good news is that tomorrow I will succinctly reveal the methodology on how to calculate Value Creation (simple formula).   The bad news is that after you read it you will disagree with me for one of a dozen reasons.

Fortunately, there is further good news.  After I give you the answer, I will explain it over several follow-up blog posts.  When I do, and then when I show real life examples, a light bulb will go off in many of your heads.  You will begin to appreciate, I suspect, the power in the methodology I set forth.

In Zayo, we actually do most of the methodology already.  Only now, however, we are stitching it all together.  I am confident that, as we do so, Zayo-ites will understand it, appreciate it, and use it as a tool to make appropriate decisions for our shareholders.  We will have a practical and appropriate way to measure Value Creation.   And we will focus on dialogue and discussion on how we are going about creating value and on how much value we are in fact creating each quarter.

Can I get an overnight drum roll please……

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Isn’t There an Easier Way?

I have shared my views on President Obama in the past.  I voted for him.  I still am glad I did, although not by a lot.  For the most part, I support his approach internationally–a topic I will write about in the future.   I don’t support his instincts on the changes he is making with one of the greatest of American institutions–our economic system.

Recently, President Obama gave a speech to the CIA.  The topic was his views on harsh interrogative techniques.  However, I want to play his words back and pose the follow question:  what if he used these words as a guidepost on how we need to tackle our economic crises? Here is the excerpt:

What makes the United States special…is precisely the fact that we are willing to uphold our values and ideals even when it’s hard — not just when it’s easy; even when we are afraid and under threat — not just when it’s expedient to do so. That’s what makes us different.

So yes, you’ve got a harder job. And so do I. And that’s okay, because that’s why we can take such extraordinary pride in being Americans.

And over the long term, that is why I believe we will defeat our enemies: because we’re on the better side of history.

So don’t be discouraged by what’s happened in the last few weeks. Don’t be discouraged that we have to acknowledge potentially we’ve made some mistakes. That’s how we learn. But the fact that we are willing to acknowledge them and then move forward, that is precisely why I am proud to be President of the United States, and that’s why you should be proud to be members of the CIA.

Our economy is in shambles because of self-inflicted wounds.  Politicians, consumers, and big business all shoulder blame.

But America was built on the beliefs and values around the inalienable right to pursue happiness.   Wealth is not the same as happiness.  And Paul McCartney convinced us that money can’t buy us love.  But one of the main reasons Americans work hard to benefit from the things that money can buy.  They are exploiting their inalienable right to pursue happiness.

So President Obama–I respectably ask you these questions:

Is the inalienable right to pursue happiness part of what makes the United States special?

Are we willing to uphold this value and ideal even when it’s hard — not just when it’s easy; even when we are afraid and under threat — not just when it’s expedient to do so?

Should we take such extraordinary pride in being Americans because we ware willing to uphold the premises of our great American economic system even when it means that, for now at least, we have a harder job.

Do you believe that over the long term the preservation of our American economic system–which is founded on our inalienable right to pursue happiness–will keep us on the better side of history?

Are you willing to tell Americans to not be discouraged by the economic recession.  Are you willing to acknowledge potentially we’ve (inclusive of all politicians) have made some mistakes?   Are you willing to say that is how we (inclusive of democrats) learn?   Are you willing to acknowledge the mistakes–in a non-partisan and intellectually honest way–and then move forward?

And finally, are you willing to commit yourself to preserve the American economic system and, in doing so, fully respect the inalienable right of all Americans to pursue happiness?

Remember, it is our economic system more than anything else in history that has produced an enormous advancement in the quality of life for people all across the globe.   Let’s cherish this.

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The past 8 posts have been part of a long series on the Value Creation formula.  The last several were a painstaking breakdown of the Balance Sheet, all for the purpose of tracking Amount Invested.   A fair question is Isn’t there an Easier Way to track Amount Invested?

A brief recap:

• Value Creation = Today’s Value less Amount Invested (simple formula)
• In the Owner’s Equity part of the Balance Sheet, Paid In Capital–Gross reflects the amount that has been invested in the enterprise from inception.
• Dividends is how much cash has been returned to equity holders
• Paid In Capital–Net is the difference between Paid In Capital–Gross and Dividend.  It is one and the same as Amount Invested.
• Forecasting the Balance Sheet into the future is as important as forecasting Revenue, EBITDA, and Capital

The reason for using the Balance Sheet to track these numbers is because the Balance Sheet, well, needs to be balanced.  That is, there are a lot of other accounts on the Balance Sheet that change each month–sometimes in a helpful way, and other times in a hurtful way.   The changes in these accounts usually trace back to decisions that are made by the operators of the business.  Or they relate to execution effectiveness (or ineffectiveness) of management.   The Income Statement of the business–that is, Revenue, EBITDA, and Capital–materially influences the Balance Sheet.   However, some Balance-Sheet-influencing management activities  are not captured in the Income Statement.  Many of these are related to Working Capital, a topic I will cover in a later post.  Some are related to other items, such as Capitalized Leases.

The use of the Balance Sheet to track and forecast Amount Invested requires that management understand all variables that impact the Balance Sheet variables.  But understanding is only step #1.  Step #2 is when the dialogue shifts to

Our job is to create value.   We have a way of measuring value creation:  Value Creation = Today’s Value minus Amount Invested.  We set financial goals around Value Creation.  We measure how we are doing against these goals.  We know how the actions we take when managing the business affect this calculation.  We are constantly learning how to better manage the business in a way that maximizes Value Creation.

Recall my earlier quip:  “you aren’t a P&L manager unless you manage a Balance Sheet“.   Is it beginning to make more sense now?.

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Amount Invested–OVS Illustration
Amount Invested and Paid In Capital
Amount Invested–ZEN Illustration
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