By Troy L. Harmon, CFA, CVA, Director of Research, Henssler Financial
Business valuation analysts generally use market data to determine the value of companies. While the market data they prefer to use is that of private companies, this information must be relevant to the company being studied. Relevant means the data should be related to companies with similarities in industry, size and life cycle (start-up, maturing or mature) in order to be useful. Relevant information can be difficult to find at times, considering many business owners prefer their information to remain unknown by the general public. This lack of data should come as no surprise. However, there is usually enough information available to get some direction. If the private company data is not enough, analysts are likely to rely on public company information to draw their conclusions. The trick to all of this is making sure the companies used for analysis are as similar as possible to the subject company being valued.
While I don’t pretend that an in-depth comparison of companies and their industry peers would be of interest to most, I believe a thought or two on the data might prove worthy of a few minutes of your time.
When looking at public financial markets over time, you can quickly note that prices rise and fall. They generally reflect the business cycle. When the economy is in contraction, stock prices are generally below their long-term average. Conversely, during recovery from recessions, prices rise from their recessionary lows, ultimately overcoming their long-term valuation averages. Although you wouldn’t expect an exact repeat of history, the wave pattern shown in the chart below around the long-term average P/E shows the willingness of investors to pay more or less than the average price-to-earnings level at various times. Directed by economic information and their outlook for the future, potential investors and asset owners come to conclusions about value that vary widely over time. The chart below uses S&P 500 Index data sourced from Bloomberg to show quarterly price-to-earnings (P/E) ratios and the long-term average P/E.
As you can see, transactions take place on either side of the long-term average given what is going on in the economy at the time. This tells us several things. First, it answers the question, “Would anyone ever sell a business for an amount below its future value?” The answer is obviously, “Yes”. On the other side of this is the idea that buyers often pay more than the business might ultimately be worth in the future.
Of course, we look at other business metrics (EBIT, EBITDA, Revenue, among others), but all of them show a similar pattern. Why they would pay more or sell for less is probably related to an emotional bias. Strangely enough, humans tend to anchor their opinions to recent events, obviously assuming prices are not likely to repeat their historic levels.
After suffering through 2008 as one of the responsible parties for a large level of assets under management, I can tell you significant market declines can bring doubt to the mind of anyone. On the other side, the example we have from the Tech Bubble of the late 1990s shows people can also fall prey to the assumption that recently rising prices beget future increases. Unfortunately, it is usually those who have feared the risk of the market who become convinced late in a recovery they should have been investing all along. They then try to catch up only to be picked off when the market corrects a second time.
This is a warning to those who are looking to buy a business. Take heed to the last portion of the chart above. The market looks expensive, and the offer prices you see are likely impacted by the market. For those of you looking to sell, the market looks favorable. For all who may find themselves in a transaction in the future, make sure any valuation you see is tempered by the long-term average and any valuation report you pay for includes a note about current economic conditions.
Investments are clearly made for varying reasons, but there may never be a transaction if everyone agreed about valuations. The seller tries to walk away believing they just unloaded a burden on an unsuspecting fool. The buyer believes they can make minor changes and realize the true value of an otherwise underpriced business they just took off the hands of an unsuspecting fool. Somewhere in the middle probably lies the true value of the business. This can become more complicated if the valuation is part of a legal issue. Make sure your valuation is defensible if it might end up in court!
If you have questions, contact the Experts at Henssler Financial: