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The main goal of investors is to discover companies whose growth and development can be supported over the investment horizon. Investors commit their capital into attractive opportunities with the expectation of receiving financial returns and accumulate wealth.
Investors look for key attractive characteristics in companies, such as:
***Business performance and prospects***
High Growth Potential – Investors will be attracted by companies with high growth potential. Although a company’s growth can be measured in many ways, the first thing investors assess is the growth the company is able to achieve by conducting its commercial activity, i.e. organic growth.
Companies with a track-record of high organic growth potential and looking to explore growth opportunities will attract investors, given consistent and sustainable organic growth is a good indicator of the business potential do reach higher future valuations.
Earnings are the subsequent area investors and analysts focus on. A company’s earnings are influenced by various factors, including operational expenses, financing, assets, and liabilities. Investors often use metrics as Return on Equity (ROE) and Return on invested capital (ROIC) to measure’s the company’s profitability relative to other investment alternatives. These types of measures are employed to assess a company’s efficiency at allocating the capital to profitable investments and accordingly they provide a valuable insight regarding how well a company is employing its capital to create value. Investors favour companies with higher ROE and ROIC as these are more lucrative.
Industry – Some investors specialize in specific industries and are more willing to invest on companies that operate in those industries, e.g. institutional investors tend to prefer industries with stable cash flows such as the Utilities sector. Additionally, some industries are more inherently attractive to a larger number of investors. Industry attractiveness depends on a number of factors but it is worth considering that when evaluating the industry attractiveness, investors analyze the following factors:
► Long run growth rate forecasted for the industry
► Industry size and market share among competitors
► Porter’s 5 forces profile of the industry (entry barriers, exit barriers, supplier power, buyer power, threat of substitutes and available complements)
► Regulatory environment
► Changes in demand
► Trend of prices
► Seasonality
► Availability of labour
► Market segmentation
***Financial features***
Sustainable leverage levels – Compared with other funding alternatives, debt is a cheap source of financing. This is accentuated by the fact that interest are deductible for tax purposes. However, high leverage increases the company’s probability of default, which in its turn will increase the cost of new debt.
Even though the adequate leverage level depends on factors which are intrinsic to the company, investors will compare the leverage of the company with the average leverage of the industry, as an exercise to assess financial risk.
While some industries tend to have higher levels of debt (e.g. capital intensive companies with more predictable revenues, such as utility providers, tend to have highly leveraged structures), in other industries a high level of leverage is perceived as excessive financial risk for potential investors. To assure adequate levels of debt, ratios such as debt service coverage ratio, Debt/Equity and Debt/EBITDA must be analysed and compared with similar companies.
(Stable) Cash flow stream – Well managed companies, able to convert earnings into cash on a regular basis. Investors tend to privilege investing in companies with a stable cash-flow stream, especially if generated by recurring operating activity. For investors, a stable cash flow stream is often more valuable than earnings for the following reasons:
► Cash flow is more reliable than earnings and profits: While profits, as reported in the Income Statement are subject to accounting policies, namely revenue and cost recognition practices, cash flow is much harder to adulterate, thus providing a more reliable indication of the business capability to generate cash.
This ability to generate cash, signals to investor that the company will be able to grow organically and fund the investment needed to achieve growth prospects, making the company a more attractive investment.
► Cash flow allows the company to fund its own growth/expansion: The ability to generate cash also signals to investor that the company will be able to grow organically and fund the investment needed to achieve growth prospects, making the company a more attractive investment.
► Cash flow provides liquidity to pay dividends: For investors who favour a stable and recurring dividend payout, a stable cash flow stream signals that the company will have the means (liquidity) to adhere to a highly predictable and stable dividend payout. For some investors this is key, because it enables them to be remunerated for their investment throughout the investment period, without having to sell shares.
Companies may improve their cash flow generating capabilities by:
► Organic growth
► Increase operating margin through cost management
► Reestructuring
► Working capital management
***Transparency and reputation***
Accounting records – Investors rely on the company’s disclosed Financial Statements accounts for their assessment of the company as an investment prospect, thus high quality accounting is a sine qua non condition.
High quality accounting is often a synonym of conservative accounting. If the company employs conservative accounting policies, investors will gain added confidence and will be able to analyse and interpret financial statements with confidence. On the other hand, aggressive accounting policies can raise a red flag to investors as the company may be misrepresenting financial performance.
Investors’ relations – Communication can take many forms, from meetings with potential investors, news releases, annual reports and setting up and maintaining your company website. The messaging across all channels should be the same and the sole goal is to inform stakeholders about the company so that they can gain a better understanding about the business, the strategy, governance, financial performance and prospects. In this digital age, there are many methods of communication which can be used for establishing your presence with potential investors.
As a company is preparing for an IPO—and especially after an IPO—the Investor Relations (IR) team, or IR for short, will play a prominent role in keeping the company highly valued and legally safe. If a company doesn’t already have a dedicated investor relations team, then building one should be a priority whether the company is pre or post IPO. There are several best practices that IR teams should follow:
► Knowing Your Investors – This means knowing how to communicate to both a general financial audience, as well as a specific group of investors.
► Managing Expectations Properly – In most cases, an IR team is primarily responsible for managing the expectations of analysts and private investors. Expectations are key to investors, who are usually investing because of their belief in a specific future. Not managing these expectations well will lead to poor valuations, or overly optimistic valuations, which will later lead to unmet expectations and damaged credibility. Thus, it is important for companies to have a high degree of awareness about exactly the type of expectations they are creating with every public statement.
► Building Credibility Through Transparency – IR teams need to develop good long-term relationships with analysts and investors. This is done by giving information promptly and by staying available to answer questions and concerns. An IR team’s job is to keep investors satisfied through the bad times, and realistic during the good times. By doing so, long-term relationships of trust can be built, which will hopefully lead to higher and more stable share prices over time.
***Environmental, Social and Governance features***
Environmental, Social and Governance (ESG) principles are a set of standards by which a company and its investors can measure the wider impact of its operations and long-term strategy. According to recent research studies, having an ESG relevant strategy is rewarded by financial markets.
Investors are becoming more and more responsible, and as a consequence, their requirements and expectations of issuers are increasing. Issuers, looking to improve access to capital and avoid activist situations, are expected to build their own ESG roadmap to engage with investors based on real and measured KPIs. A relevant ESG strategy leverages the right narrative and ensures long-term financing.
Investors increasingly expect companies to recognise and address, in an accountable way, the short and long-term risks and opportunities in relation to ESG factors that impact long-term value creation. In parallel, Asset Managers have begun changing their investment criteria, incorporating ESG factors into investment decision-making, and by supporting the allocation of capital to sustainable initiatives.
Early adoption of good governance practices primes companies to take advantage of this trend and respond more effectively to the expectations of their various stakeholders (shareholders, employees, civil society, etc.), as well as increasing their visibility.
Here are some of the main points to consider:
► Diversity is key – Diversity is a carefully monitored criteria in good governance practices. In addition to diversity of skills, profiles and ethnicity, the proportion of women in managing bodies is also being considered.
► Executive pay – Executive pay has become a subject of debate between issuers and investors. Investors have high expectations in this area. They expect, in particular, increased transparency on variable pay criteria and internal pay gaps. Furthermore, in most listed European companies, ESG criteria are used when calculating the variable portion of executive pay.
► Increasing engagement in ecological transition – The Covid-19 pandemic has heightened awareness of the need for sustainable economic development. The European Commission, for example, urged member states towards more environmentally friendly and resilient growth as part of its recovery plan. Investors are following the same trend. Investors are increasingly holding the management bodies of these listed companies accountable, both on environmental issues and social responsibility. Besides the ethics and moral motivations, investors demand this accountability given studies have shown that the more a company applies ESG considerations, the better its share price performs and has less volatile dividend yields.
Many private companies, especially start-ups, may lack the resources and expertise to develop and implement a strategy to manage ESG risks and opportunities. In such cases, companies may consider hiring employees with expertise in high-priority sustainability issues or shifting existing staff into ESG-focused roles to develop internal expertise. Corporates may also consider working with consultants to jump-start a sustainability strategy.
