Deloitte SA Blog

This article, produced by the Deloitte Strategy and Innovation team in South Africa, introduces ways to improve management forecasts, as well as affording management the ability to track performance, identify where strategic intervention is required and enables management to drive for value in a more disciplined manner.

The forgotten art of using experience curves to improve management practices

In an increasingly competitive business environment, a management team’s ability to accurately forecast its costs and productivity is a key driver of business value. Experience curve theory is a powerful analytical methodology that can support a management team in determining realistic and measurable forecasts based on specific industry benchmarks and achievements.

This article outlines Deloitte’s point of view on how the experience curve can be leveraged to support leadership teams in setting realistic targets and then managing value. With a focused approach, the experience curve forecasting and monitoring process becomes a key enabler to realising superior productivity enhancements.

Download the full article . . . .

What are your views relating to this approach to driving operational efficiency and improving forecasting? We would love to hear from you!

It may be a cliché that entrepreneurs provide the energy for economic growth, but just like taxes and death are a fact of life, it is also a fact that vibrant economies have a large number of start-up businesses striving to get a foothold in markets. The economies that have grown the fastest in the last two decades, according to a study by Aswath Damodaran (Professor of Finance at the Stern School of Business at New York University), have been those that have a high rate of new business formation. Thus, the US was able to generate much more rapid economic growth than Western Europe during the 1990s, primarily as a consequence of the growth of small, new technology companies. Similarly, much of the growth in India has come from smaller, technology companies compared to established companies.

Research in the United States also shows that young businesses are the biggest employers. In a study of the biggest creators of jobs, the National Federation of Independent Businesses estimates that about two thirds of the new jobs created in the United States in recent years have been created by small businesses and start-ups. This finding, coupled with the fact that start-ups are mostly the drivers of innovation in the economy makes them a very vital component of a vibrant country. Young businesses are even more important in a country like South Africa that is faced with the challenge of high unemployment rates and slow economic growth.

One of the most challenging things in one’s life beside marriage may be turning a start-up business into a successful company. These challenges lead to many start-up businesses not surviving the test of commercial success and failing. A study of 5 196 start up companies in Australia found that 64% of the businesses failed in a 10-year period and in the US a study done also found that 44% of the start-ups don’t make it beyond 5 years.

Due to the high failure rate of start up companies, valuing them properly becomes very critical for those venture capitalists who are interested in these young companies. However, valuing start companies is difficult for a number of reasons. For example, some start ups are operating at a loss and have negative cash flows. Those businesses that are generating profits often have a short trading history making it hard to determine sustainable Earnings before Interest, Tax, Depreciation and Amortisation (“EBITDA”) and cash flows, which makes it difficult to prepare reliable financial forecasts for start up companies as they do not have a long trading history. As a result most of the conventional methods of valuation such as the traditional Discounted Cash Flow (“DCF”) or comparables methodology either don’t work or they yield unrealistic results, resulting in venture capitalists funding wrong start-ups.

Most venture capitalists prefer using the venture capital method to value start-up companies. This method requires an investor to estimate revenue in the future and multiply this by a comparable companies’ Enterprise Value/Revenue (“EV/revenue”) multiple to get the enterprise value (“EV”). This EV is further reduced by a rate that compensates the investor for the high risk taken and may be as high as between 60% and 75%. This reduction takes into account the risk of failure of the start–up business. Using a formula where Y represents the percentage of ownership and x represents the capital injection to be provided by the investor, the percentage of ownership the venture capitalist is entitled to is calculated as follows Y= x/(x + EV).

According to Damodaran there are a number of problems with the venture capital method namely:

• It focuses on revenue estimations only.
• It does not estimate cash flows achievable in the future and the uncertainty of achieving them.
• The rate used to further reduce the enterprise value is an arbitrary rate   .
• The capital injection added to arrive at post money must be the capital that is going to be used by the company in its operations and  no portion of it should be given to existing equity holders.

A more practical appropriate method that addresses most of the shortcomings of the venture capital method is the Adjusted DCF also referred to as the Top Down approach in some studies. The steps involved in the method are the following:

1. Potential Market for the product/service: the first step in deriving the revenues for the firm is estimating the total potential market for its products and services. The issue here is that the valuator has to accurately define the products and services of the start-up as this has a direct bearing on the market size. Companies such as Data Monitor are often used to source data on estimated market sizes and forecast trends in South Africa.
2. Market Share: to estimate the share of the market that would be captured by the start-up business, valuators need to consider a number of things like the quality of the product or service, the quality of the management team of the start-up and resources the business can draw on to achieve the envisaged market share. From this market share the revenue amount can be estimated.
3. Operating expenses: The valuator will also have to estimate the operating expenses of the start- up. The operating expenses can be estimated as a percentage of revenue and also taking into account the specific management plans.
4. Investments for growth: the investments in working capital and capital expenditure required to achieve the estimated growth must be determined. These investments will contribute towards things like R&D, registering new patents, enhancing the products and acquiring experienced competent staff. This number is important to the investor in the start-up business as it also indicates the amount of recapitalisation the start-up company might need in the future.

From the above estimates the cash flow from operation can be estimated and be discounted at an appropriate cost of capital for the start-up business. The terminal value can be calculated using the Gordon growth model and also be discounted at the same cost of capital rate. The only significant departure from the traditional DCF in the adjusted DCF is the calculation of the revenue line.

It is very clear that for a country such as South Africa to grow its economy and address one of its biggest ills, unemployment, there has to be huge interest in start-up businesses. Investors also have to substantially increase the portion of start-ups in their portfolios. It is also clear that appropriate valuation methods such as the adjusted DCF have to be used to value start-ups as inappropriate methods may lead to investing in failing businesses. In the case of choosing appropriate valuing methods and also valuing start-ups correctly using experts such as Deloitte Corporate Finance could yield substantial results to the investors and also save them huge losses in providing funding to incorrectly valued businesses.

Article compiled by Tumisho Komane (Manager at Deloitte Corporate Finance) and Charles Larbi-Odam (Director at Deloitte Corporate Finance)

References

¹Aswath Damodaran, 2009, “Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges”

²John Watson and Jim Everett, 1996, “Do Small Businesses Have High Failure Rates?” Journal of Small Business Management, v34, pg 45-63

³Knaup, Amy E., May 2005, “Survival and longevity in the  Business Employment Dynamics data,” Month Labor Review, pp. 50-56; Knaup, Amy E. And MC. Pizza, September 2007, Business Employment Dynamics Data: Survival and Longevity, Monthly Labor Review, pp 3-10.

In many respects, SA is seen as the Hong Kong of Africa, as the platform from which to launch expansion into Africa. International companies are appointing South African advisers, particularly to provide due diligence support on transactions.

Africa holds great investment potential for both domestic and international investors. The fact that businesses on the continent weathered the economic downturn is a success story in itself, according to Nisha Dharamlall, due diligence partner within corporate finance at Deloitte.

“Africa is the second-largest continent in terms of both area and population, with a market of close to a billion people.

“Africa accounts for 30% of the world’s mineral resources but less than 7% of the world’s metal production (this sector is definitely an attraction for Indian and Asian multinationals); it has the fourth-largest oil reserves in the world. Half of the population is under the age of 20, which indicates that Africa will be the workforce of the world in the future.”

Dharamlall adds that many foreign investors are pleasantly surprised at the level of skills they find in Africa, and a more recent trend has been the return of some of the African diaspora.

“An increasing number of Africans who left during the 80s and 90s to study and work abroad are returning to their homes, bringing with them the wealth and knowledge they have gained internationally.”

In many respects, SA is seen as the Hong Kong of Africa, as the platform from which to launch expansion into Africa. International companies are appointing South African advisers, particularly to provide due diligence support on transactions.

“They are beginning to understand that a sound due diligence encompassing financial, legal, tax, regulatory aspects etc, is imperative to gaining a thorough understanding of the risks and opportunities associated with the targets in Africa.”

SA has proven and established legal, banking and regulatory systems that are attractive to foreign investors, and our relatively low labour costs also present an opportunity for global companies to establish a manufacturing presence in SA with a view to exporting into Africa, Dharamlall notes.

In the past, Africa’s attraction has been the natural resources – oil, gold and diamonds – but consumerism is a huge factor. With the continent’s massive  population, all growing their disposable incomes and buying cars, cellphones and products from retailers, investors looking for growth are keen to invest in Africa.

“Many of the M&A deals under consideration in Africa in the past year were strategic in nature as opposed to opportunistic, with the key driver being to gain access to the continent’s distribution networks, particularly in the consumer products and financial services sectors,” continues Dharamlall.

“A thorough due diligence provides organisations with confirmation that these distribution networks exist and are secure.”

Individual Chinese acquirers are looking to buy abroad in order to expand their market share and, to varying degrees, promote their brands on the global stage.

“The preferred destination for such a promotion very much depends on the product in question: Chinese manufacturers of low-end consumer products will probably look to expand where there will be a ready market for their products, such as in Africa,” Dharamlall says.

“Many companies are sitting with large amounts of capital on their balance sheets that need to be deployed to provide returns for shareholders.”

It is expected that that money will not go to the US, which is experiencing a double-dip recession and, as Europe is in disarray, that capital is going to come to Africa and South America.

“With limited growth forecast for developed countries, one can expect to see large multinationals increasing their focus on developing countries.”

Dharamlall says SA’s marketplace is also seeing a far greater number of Chinese investors than in previous years and, contrary to popular opinion, the Chinese interest extends well beyond resource assets, and now includes construction, diversified industrial and financial services assets.

“Chinese investment in infrastructure projects across Africa is sure to stimulate economic growth over most sectors.”

There has also been a trend towards consolidation within the banking sector in Africa, which has led to interest by the local banks. The large unbanked sector provides a great opportunity to local as well as global banks.

Dharamlall cautions: “It is very important when entering a new market to seek advice from local experts on regulations, infrastructure requirements and brand/reputational issues. In Africa, there are 53 different countries and legal jurisdictions, with different cultures and languages. You need local assistance backed by global methodology, to perform the research and networking, in order to create sustainable investment.”

Nisha Dharamlall is a partner at Deloitte Corporate Finance.

This article initially appeared on the BusinessLive website.

You and your valued clients are invited to attend the risk event of the year! Due to limited numbers, your RSVP is essential.Deloitte is sponsoring the venue for the Gauteng Information Security Group of Africa  chapter meeting, a Section 21 company established in 2005.  An interactive panel discussion with several local and international experts will be chaired by Craig Rosewarne from Risk Advisory.  A number of members from both public and private sector organisations as well as delegates from the press will be in attendance.The event takes place on the 25th March (starting 8:30 and ending at 4:00 pm) at Deloitte, Building 33, The Woodlands Office Park, Woodlands Drive, Woodmead, Johannesburg, Gauteng, South Africa.    Discussion topics will include: The importance of skills development in Africa Test of Courage – What is your risk appetite? Innovative learning into the 21st Century Enterprise Risk Management – the Risk Intelligent approach Business perceptions of their Governance, Risk Management and Compliance functions  – Suggested action points Aligning business to IT – Valuable feedback from the 2011 IT-Business Balance EMEA survey The role of Analytics in Risk Management Aligning Integrated reporting with the Business Strategy The RA Foundation challenge  Cyber Security & Information Security challenges facing Africa.

Join an interactive panel discussion comprised of local and international experts to find out what lessons Africa can learn from international initiatives and challenges faced in other countries across the world. For more information, or to RSVP please contact Dawn Cracknell on dacracknell@deloitte.co.za