Understanding Business Valuations
When private businesses are put up for sale they generally have a professional valuation done by a business valuator. Similarly when a prospective business purchaser is looking at buying a particular business they have an independent valuation done which is also performed by a business valuator.
Just like a real estate valuator who values property, business valuators value businesses.
A common method business valuators use to value a business is the discounted cash flow method. These valuations are largely based on what prospective business purchasers are willing to pay for a business. After all there is no point in valuing a business at such a high price that no one will ever buy it.
Typically the business seller's valuation will be slightly optimistic and the prospective business buyer's valuation will be slightly pessimistic. This is exactly the same with real-estate where the seller seeks a higher price and the buyer is looking for a better price.
Thus the process of negotiating begins and the final sale price ends up being a compromise between the two parties. This is the same whether it's a real-estate sale or a business sale.
The prospective buyer of a business is primarily concerned with the annual profit that the business in question will make based on the purchase price. Private businesses with a stable earnings history which are fundamentally sound tend to sell for around five times their annual profit. That is a PE ratio of 5? Compare this to the typical PE ratios of listed companies of around 15 to 20 and the stock investor may well wonder why such a discrepancy between private businesses and public companies
Some investors will justify the discrepancy in PE ratios between public companies and private businesses as being due to the relatively small size of private business. While market-cap size is certainly a factor it does not account for the average PE ratio of around 15 to 20 for large-cap stocks. In fact business valuations suggest that their PE ratios should be around 10.
Further more the PE ratios of small-cap stocks with stable earnings histories will often have PE ratios well above 20. This is the exact opposite of what they should be? The general justification is that they have more growth potential thus the higher PE ratios are justified. The problem with this is that they have much higher risks and investment philosophy states that the greater the risk is then there should be a greater compensation. This implies that the PE ratio should be lower and not higher. In fact that is exactly the way it is with private businesses. The smaller they are, the lower the PE ratios tend to be.
So what else explains the difference between private businesses and public companies?
To understand this, the reasoning behind the private business buyer needs to be understood. A prospective buyer of a private business has the option of placing their capital in a guaranteed investment such as Treasury bonds which might be currently paying a 5% coupon rate. This effectively gives a guaranteed return but it is a low return. For a higher return an alternative is to buy a private business and of course they will want a significantly higher return than 5% for the risks involved.
Let's suppose the prospective business buyer has $1 million to spend. They could simply buy $1 million in 10 year Treasury bonds at 5% and receive $50,000 a year effectively guaranteed. Further more their invested capital is secured and will be returned at maturity.
Prospective buyers of a private business are primarily concerned with the income that the business will generate. The resale value is not of prime concern as private business owners buy a business with the intention of running the business over the long-term which means decades.
When buying a business there are all sorts of risks, even with a business which has a stable earnings history. All it takes is for a large competitor to enter their industry and the likelihood is that the prospective business will be hit hard, both in reduced earnings and with reduced resale value.
Thus nobody in their right mind would pay $1 million for a business that only makes $50,000 a year since they can get this from Treasury bonds effectively guaranteed. To pay $1 million the prospective business buyer will want considerable more annual profit than a lousy $50,000 to compensate for all the risks.
So if Treasury bonds are paying 5% what would a prospective business buyer look for with a private business? This largely depends on the risks of not receiving the profits into the future. After all nobody wants to spend $1 million and get nothing back. Business buyers are paying around five time's annual profit for business with stable earnings histories. This works out to 20% annual profit or $200,000 a year for a $1 million private business.
Business buyers pay around five time’s annual profit
for business with a stable earnings history
The noticeable difference between a prospective buyer of a private business and a stock market investor is in the way they treat what they have bought.
- The private business buyer is concerned about how much profit the business will make for the capital used to purchase the business. They are primarily interested in the income and hold these businesses for decades - and even hold them through economic recessions.
- The stock market investor for the most part is only concerned about the stock price going up and has no real interest in the company's profits, other than if it can be used to justify an even higher stock price. Stock market investors often have short-term views and will often sell when stock prices fall.
Stock market investors are generally not interested when a company pays a dividend because it is such a small amount. The dividend is small partly due to the high price paid for the stock.
Stock market pundits have a misguided perception of risk. A lot of stock investors are really only investing in a rising stock price rather than investing in the business. They have no interest in the company's business or they are even not even aware that it is a business in the first place. This is highlighted below in Figures 1. and 2.
Figure 1. Investors buy stock
due to uptrend
Figure 2. Business buyers buy at business valuation
From Figures 1. and 2. above, looking at a stock for what it really is - which is a business - puts the stock price and its associated risk into perspective. A lot of stock investors especially beginners will over pay for no other reason than that the stock price is in a strong uptrend. Unfortunately this makes the stock price vulnerable to a correction and bear markets are especially cruel to overly inflated stock prices. Bear markets are simply a process of ridding the market of excess prices.
Private business buyers simply pass up on a business if the price is too high and the returns are not adequate to justify the risk. In stark contrast some stock investors are under the illusion that the higher the stock price is then the safer the investment is. This attitude simply turns a moderate risk investment into a high risk investment.
Stock investors can learn a lot from private business buyers. The famous investor - Warren Buffett thinks like a private business buyer and when he evaluates listed companies he only buys at prices which will provide a satisfactory return for the risks taken. The article Valuing Stocks like Bonds gives examples of how to estimate the future return.
Stock Analysis for Finance Students and Investors