Understanding how stock markets value businesses seems to many to be a dark art. Never more so than in times such as the past few trading days when valuations (reflected in stock prices) have been alarmingly volatile. How are listed companies valued? Do similar principles apply to small businesses, and what are the implications for small business owners?
Businesses are generally valued on the basis of a multiple of earnings (see the papers for the daily price-earnings ratios implicit in publicly listed stock prices). Yes rocket scientists, its much more complex than that, but even you will concede that the NPV of future maintainable earnings can be reduced to some kind of earnings multiple.
This principle applies to large and small businesses alike.
So if a business is valued at a multiple of its earnings - what is the "multiple", and how do you define "earnings"?
The last bit first - earnings these days are generally defined as EBITDA - earnings before interest, tax and depreciation. The rationale for adding back interest is that the value of the business should not be determined by its debt structures.
As for the applicable "multiple" - that depends on the sustainability and quality of the earnings - and "volatility" in yearly earnings is a surrogate for these two factors.
How should you advise a small business owner looking to increase the value of their business so they can sell to a generous competitor and retire early?
Firstly, my bias is for business growth over cost cutting to achieve better quality earnings. Cost cutting can enhance the bottom line in the short-term, but for long term sustainable profits, the fundamentals need to be looked at.
Which leads me to my second point. A business - no matter how small - that dominates a market segment or niche, is going to enjoy greater earnings and attract higher multiples. So the small business owner should be focused on looking for market segments or niches to "own" in order to increase the value of their business.
Given that "earnings" for valuation purposes are before interest, using debt to grow the business should be seriously looked at - subject obviously to risk and the ability of the owners of the business to employ the debt funds profitably.
Are small business valuations as volatile as stock prices? Market forces still apply - supply and demand, the cost of money and the general availability of funds. Lower multiples apply when interest rates are high. And if credit tightens at the retail level, then this will impact on business valuations in the same way other asset prices are effected. What do you think?
The Cash Flow Ninjas
