One of my close friends' family was manufacturing a commodity (let's say screws) used by many companies in Nifty 50 and Nifty Next 50. His grandfather started the business, which his father and his uncle ran. Due to my friend's uncle's death, they had to separate their joint families now.
A crucial part of separating joint families is first to value the assets and then do the split where each can choose which assets they want, and then the leftover balance is either settled in cash or in future payables. They had some real estate and a business. While valuing real estate, one can use comparables of other similar properties, valuing the business was tricky.
Let's talk about the business. They use specialised expensive machines to manufacture screws. They have to purchase raw materials and have to hire specialised people known as operators to run those special machines. Managing and running operators is complex, and the owners must understand the job themselves so that operators can't hold them hostage. Once an operator has "set" the machine's configuration, that machine can start producing the product while the operator can set other machines. As the number of machines increases, operating leverage kicks in.
These are the good parts of operating leverage, but through my friend's narration, I learned other things. His competitors had far more operating leverage than him by having more machines and thus they could get more efficient use of operators' time and were able to pay operators more than what he could afford. They were in a losing battle at worst, and a trainee ground at best. The big companies who were his customers also preferred to deal with a few vendors who can satisfy many of their needs rather than have a single vendor for each product since their procurement function is exhaustive, which makes having more machines critical to acquiring and retaining customers.
But none of this was the nail in the coffin.
They had purchased their machines at least one and a half decades back. Some of the machines had stopped functioning and had to undergo severe repairs, and at any point, they could completely give up. My friend estimates that they would last two years in the best-case scenario. This is where things go from bad to worse. In the coming two years, they would have to invest significant amount for the machines (which have to be imported) to maintain that cash flow. This would make their total investment in the business not worth the cashflow it produces.
The re-investment was no longer the logical choice. The maximum value of the business would be $ \frac{X}{1+r} + \frac{X}{(1+r)^2} $, where $ r $ is the discount rate.
As it turns out, if your business depends on suppliers from other countries, their inflation can affect your business especially if your suppliers have pricing power. Being sandwiched between suppliers who have pricing power and customers who have pricing power, is no fun and leads to suffocation. Best to use those temporary cashflows and reinvest them in something other than the business.
Imagine the horrors of valuing such a business based on the Price to Earnings (or P/E) ratio.
