It is common to hear from broker/intermediaries: “That business is worth 3 times earnings“. In part I and II I talked about the basics of what “earnings” are. Here I’ll talk about the “3 times” part of the equation.
Remember I said that future earnings are what it is all about? Well, if you take a future earnings stream and discount that back to current dollars, that is vaguely similar to just taking past earnings and multiplying it by a factor (assuming that past earnings predict future earnings). That factor, for SMBs, has historically proven out to be between 1.5 and 5 times discretionary earnings with the bulk between 2 and 3.
For small companies (discretionary earnings under $150K) the average over the past 25 years has been about 2.2 times earnings. Lower for service and retail, higher for manufacturing. Why seemingly so low? Well, at that level the old saying rings true, you really are “buying yourself a job”. It may be a pretty good job with some nice benefits, but there isn’t much left over for a true return-on-investment. Larger businesses truly spin off enough cash to provide ROI, and the earnings multiples rise. They are still limited because of the risk and non-liquidity of the business. My partner Fred Hall, a trained business appraiser, did a study of multiples and business size and found the multiples continue to rise with size right up until the company is public. The P/E ratio of a public company (Google’s P/E was 45 last Friday, GM’s P/E 11) is roughly – very roughly – the same as our DE multiple, although the main difference is P/E is based on after tax earnings so the multiple will naturally be higher.
How to pin down a multiple? Well, many business brokers / intermediaries will guess. They may produce a beautiful report with a worksheet with such questions as:
- Rate Company Location…
- Age of Company…
- Stability of Company…
But it is still a guess with some very subjective answers. You may as well have a worksheet with such questions as:
- Rate Company Location…
- Is This a Sweet Company..
- Is this a Really, Really Sweet Company..
In truth, the guess may be dead-on to the price that the market will bear (officially called the Most Probable Selling Price). Many experienced brokers intuitively know the market well enough to make very good guesses. Or it could be a bad guess.
A trained business appraiser will use the best valuation approach for the company. Unless it is a high growth company, most small to mid-size companies are valued based on the Market Approach. Similar to how a house is appraised (but heavier in statistics), the appraiser using the market approach searches the “done-deal” databases to find business similar in nature and size. Then he does a statistical analysis to nail down the multiple.
These valuations are much less subjective because they use real-world transactions. Because, after all I said about future earnings, there is some affect because of the desirability of the business (say a sail boat charter business at Lake Tahoe vs. a butcher shop in Bakersfield), and the Market Approach will capture that.