The Power of Scenario Planning

The power of scenario planning: three initiatives to increase value by 30%

Scenario Planning; A company valuation is simply a function of current and forecast profits and cash flows. If a company can generate higher profits and cash flows or reduce the risks in the business, then the present value of the business will be higher.

People scenario planning Unusual result

So, here’s the fun part: by tweaking the financial inputs in the model, the answer changes. This is obvious in theory and incredibly valuable in practice. By making the right strategic decisions, significant value can be created in your business. This ultimately leads to more dividends and a higher price if you do decide to sell, which means the reward for your efforts is greater than it may otherwise have been.

We are passionate about giving founders the tools to understand their businesses and the value creation journey. The bizval valuation tool demonstrates the most important drivers of value and where you should be focusing your efforts as a founder.

In this article, we will look at how a retail store can increase its value by 30% through improved gross margin management.

The base case: a R4 million valuation

In this example, we have a retail store that has annual sales of around R4 million. The margins are strong, with a selling price of R250 for a product costing R100. This is a gross profit margin of 60% or a markup of 150%.

Sounds delicious, doesn’t it? These are great margins but there is usually room for improvement in any business, regardless of its size.

Our base case valuation is R4 million (a Price/Sales multiple of 1x) and we will now explore how this can be increased through certain management initiatives.

Growing the value by 30% through three initiatives

The first is to reduce theft of stock, a challenge for most retailers. By spending an additional R2,000 per month on security, stock losses can be reduced by R10,000. This is clearly a no-brainer decision.

It gets trickier after that. Price sensitivity is one of the toughest things to assess and manage for retailers, as a change in pricing drives a change in consumer demand. The extent of that change is known as price elasticity of demand and the only way to really measure it is through trial and error.

In this example, the founder notes that competitors are charging around 5% more for a similar product. The assumption is that prices can be increased by 2.5% without impacting demand, something that the founder will manage carefully.

This 2.5% increase adds R100,000 to annual sales. Combined with the reduced stock losses, gross profit is already better off by R220,000 per year. The security will cost R24,000 per year, so that’s a net benefit of R196,000.

The founder has one more initiative underway to increase value: better supplier discounts achieved through a consolidation of suppliers and associated bulk discounts. By dropping down from five suppliers to three, the founder has managed to negotiate a rebate of 2.5% on the cost of goods.

Here’s a summary of what has been achieved, without going into detail on other expenses that aren’t being changed through these initiatives:

Before

After

Sales (+2.5% pricing)

4,000,000

4,100,000

Cost of sales (2.5% rebate)

-1,600,000

-1,560,000

Reduction of theft

120,000

Gross profit

2,400,000

2,660,000

Security system

-24,000

Total

2,400,000

2,636,000

The difference is an additional R236,000 in annual profit before tax. What does that do to the valuation?

By the time we run it through the model, the value increases from R4 million to R5.2 million. That’s a 30% increase, or the value of an apartment in a major South African city!

Interestingly, the earnings multiple method experiences a higher percentage increase than the discounted cash flow method, as these initiatives deliver immediate benefits rather than cash flows that will only be realised in future years.

For this reason, we use different methodologies and weight them appropriately. Founders create value through a combination of strategic initiatives (typically with longer-term benefits) and tactical plays that deliver short-term improvements in profitability.

By running two scenarios through the bizval valuation tool, the founder has put together a plan to increase value by 30%. It’s easy to dream up initiatives of paper of course, as practical implementation is what really counts. The important point is that “managing for value” means prioritising initiatives and understanding the impact they will have.

Begin your bizval journey today and start managing for value.