Why Your Company Isn't Worth 20 Times Earnings
Wall Street's ups and downs don't affect the value of private businesses
Watching the gyrations of the stock market is enough to turn a business owner green
with either envy or nausea, depending on which way prices are heading. When stocks are going up, does it mean your company could be worth more than 20 times earnings, too? When stocks are down sharply, as they were last month, does that mean your company is suddenly worth 20% less than it was earlier this year?
The answer is no on both counts. Business brokers say stock prices have little short-term bearing on the value of your company. "We don't even pay attention to it except for our own personal finances," says Brad Zastrow, president of Premier Business Group, a brokerage in Buffalo Grove, Ill.
Cash flow remains the primary factor in valuing a small business, because someone buying a company will be responsible for real expenses -- debt, operating expenses, and other routine costs. So, unlike Wall Street, an owner can't pay 10 times revenue, because he won't make payroll. In addition, the owner will want a decent cash return on investment, plus a generous salary for himself. "Many people who are buying a business are literally buying a job," says Bob Evans, president of the American Business Group brokerage in Dallas, so they're very careful not to overpay. "It's much more rational than the public market."
You might see valuations expand toward public-market levels if you own a somewhat larger company
-- $10 million or more in annual revenue -- and you find a "strategic buyer" seeking quick entry to a new market. But those deals are often one of a kind, so you can't just slap the same valuation on your company. What's the upward limit? Evans, who is also president of the Texas Association of Business Brokers, pegs it at around six times cash flow for larger, more-established small companies. By contrast, the average public company at midyear sold for more than twice that level, according to Zacks Investment Research.
Sometimes, the movements of the stock market can be contrary indicators for small-business values, with rising stock prices siphoning off buyers of private companies. After all, Zastrow notes, buying a small business is risky, complicated, and requires hard work. Why bother when stocks have been rising 20% or more per year since the end of 1994? In fact, Zastrow says his staff had been hoping stocks wouldn't rebound so quickly from their August sell-off, because the lower returns might make owning a private company more attractive.
Another cap on small-business prices is the increasing sophistication of buyers, says Stephen Land, president of New England Business Brokers Inc. in Burlington, Vt. A decade ago, buyers rushed in with money they made from the market and real estate. "They way, way, way overpaid," Lande says. Today, he says, "buyers are getting better advice. People want to know what they're getting for their dollar."
The result, of course, is lower valuations, and thus lower prices for your business than you'd get from the public market. Is that fair? Sure, say the brokers, owning a small business is riskier because it's more likely to get wiped out by big competitors.
The flipside is that while the strong market doesn't inflate the value of your business, the sudden plunges don't mean that your company is worth less than it was a few days before. Unless the market is forecasting a general recession, your cash flow and your company's value should remain intact. The fact is, many big market moves are utterly meaningless. Benjamin Graham, the legendary Wall Street investor, was famous for suggesting that owning stocks is like going into business with a moody partner named Mr. Market who offers each day to buy you out or sell you his stake -- with the price varying wildly according to whether he is feeling optimistic or worried.
There's no similar way to track small-business prices, but one indication of strong demand comes from VR Business Brokers in Newport Beach, Calif. The firm reports that prices in some sectors are rising at double-digit rates over last year, and sales of small businesses are taking an average of just 174 days this year, compared with 192 days in 1997. Not exactly a day trade, but then, you don't have to endure the tirades of a manic-depressive partner like Mr. Market.
By Rick Green in New York
Back to top of story