You may expect that the value of businesses are down, and in an overall sense that is true since earnings are generally down. However, the measure of value in a business is the multiple of earnings – for public companies it is the price/earnings ratio (P/E), for middle market companies it is the multiple of EBITDA (earnings before interest, taxes, depreciation and amortization) and for smaller companies it is the multiple of discretionary earnings. All of these earnings numbers are a little different, but close enough we can compare the multiple of earnings in broad strokes.
Like any market, it really is a matter of supply and demand. For example, it is easy to see that demand for public companies (i.e. buying stock) is not very high right now. For example, the P/E ratio of the S&P 500 has declined from around 22 earlier this year to around 15 currently. In fact, some investors look at a low market P/E ratio, such as the Dow Jones, S&P 500 or Wilshire index to gauge when to get back into the market, under the theory that it will certainly rise back to historical averages as investors regain confidence.
Middle Market Valuation Mulitples
Summary: Valuation multiples are holding steady because although supply is down, there are enough factors keeping demand for businesses high enough to support traditional valuations.
In the middle market (Sales $10 million to $100 million) we’ve seen the valuation multiple hold fairly steady at 4-6 times EBITDA, down only slightly from years past. Certainly the supply of good business listings have decreased because many companies are not performing well enough that they would be able to get a price they would be interested in. But the demand side is more complicated. There is downward pressure on demand from the fact that some companies are not in a financial position to buy, but this is somewhat countered by the fact that larger companies are now focused on buying smaller, “easily digestable” companies. In the middle market, everyone is easily disgestable by someone.
Adding to the demand are private equity firms that have raised their funds and need to deploy the money. Like corporate buyers, the PEGs (as shown in a recent survey) are also looking at smaller companies that can add to their existing portfolio. Some PEGs rely on the credit markets to leverage their deals and are having trouble getting some of their deals done, but we expect them back in force next year as the credit markets ease up. It is also interesting to note that recent reports have shown that PEGs have had no trouble raising money this year. It makes sense when you think about it – where else are investors going to go right now for decent returns? In any case these funds are sitting there, putting pressure on the PEGs to go out get deals done.
Finally, there is also upward pressure on demand from public companies wishing to bolster their performance. We have two such buyers that we are working with now. Their earnings have weakened and they are extremely interested in doing something to offset that.
The end result is that if you are fairly stable and performing in this economy, you have something that stands out, has value and is in demand.
Summary: There is upward pressure on demand for businesses from displaced workers, but we don’t know if that will support prices until the market is “fixed” next year by getting SBA funding flowing again.
The supply and demand for smaller companies (earnings below $250,000) is harder to see. Like larger companies, supply has decreased since many small business owners are focused on day-to-day business and not selling. It is also easy to see there is downward pressure on demand because the home equity that was used for down payments in the last ten years is all but gone. However, there is an upward pressure on demand during hard times because out-of-work employees look at becoming business owners, either from choice or necessity. Unfortunately, right now the market for small businesses is not exactly a free market, at least as we experienced it in the last few decades with liberal SBA financing. In other words, we can look at supply and demand all we want, but the market as we know it is temporarily broken. The good news is that the fed and leading SBA lenders such as CIT Small Business Lending are working hard to get that money flowing again early in 2009. Then we’ll be able to see if the increased demand from displaced workers will keep the prices up. I think they will. The general rule of thumb is that small business prices are surprisingly constant through good times and bad, ranging from 1.5 to 4 times earnings.