This post will outline some basic approaches to "back of the envelope" valuation techniques. These aren't really valuations - just structured guesses based on insufficient analysis. That's why most of this post will focus on the limitations and dangers of using shortcuts when due dilligence is called for. Nevertheless, simple approaches to thinking about value are essential tools - as prioritization devices if nothing else. There are three methods presented here - P/E or price/earnings, P/S or price/sales, and price/employee - which is trickier than it sounds.
For those who want the bottom line first, the simplest form of value calculation is bottom line ratios - for example, in some industries the average price earnings, or EBITDA ratio (price of the company divided by earnings before interest, tax, dividends and amortization) may be 5:1. If the company you are looking at has a higher ratio, it is either overpriced, includes a spurious earnings hit that the market has priced out, or is expected to grow faster than the industry on average. All other things equal, if you want to roughly compute the market value of a private firm in this industry, look at the EBITDA from the Income Statement, multiple by the industry average, and you should be in the ballpark. Similar ratios are price to sales (price of the company divided by gross sales), and my personal favorite: margin to market share(this one's complicated - it's an aggregation of the firm's profit margin, the firm's market share, and the general performance of the industry... all of which are readily available. In general, this ratio gives a weighted percentage of the overall industry value that should be attributed to this particular company). We will explain the first two of these in detail below, but they are all fundamentally rotten, and here's why: GAAP is a joke. GAAP stands for Generally Accepted Accounting Principles, which all businesses supposedly utilize. They don't. How and when you recognize sales matters for ratio calculation, but firms don't all do it the same way. If you contract for R&D versus running an inside lab as an independent wholly-owned entity your financial statements will differ, even if you spend the same amount. These are just examples, and there are many more available. Still, as a general measure of the direction of the wind, they are enough so long as they are understood in that context.
Theoretically, capital structure and organizational structure shouldn't matter to the value of an organization, but they do, and they impact earnings. Because of the I and T in EBITDA it isn't a very good surrogate for cashflow. Suppose two otherwise identical companies differ in that one owns $1 million worth of equiment outright, and either expensed or fully depreciated the asset, while the other owes $1 million to the bank at 10% interest. Personally, I'd like to pay $1 million dollars less for company B than A. A simple EBITDA ratio, however, would value the firms equally, and this is ridiculous. If a third company, otherwise equal, has been paying off a liability claim from a discontinued product line, and the last payment was made in the current reporting period, it will show a lower EBITDA than its peers. Worse, suppose a fourth company is about to start payments on a structured settlement that will persist for 5 years... an EBITDA ratio won't reflect the situation. The bottom line here is that while any or all of these circumstances can be ignored as being "unusual"... there are always unusual circumstances, so the generic valuation guidelines always have issues of some sort - only the scope and significance change. Caution must be your watchword as you proceed.
There are a bunch of basic business principles that form the core knowledge base upon which top-tier MBA's are built. When you sit through the lectures and mathematics during your first year of B-school you tend to accept these as "truths we hold to be self-evident". You then spend the second year trying to learn how to violate each and every one of the fundamental tenets - ethically, of course! With advance apologies - many of those who have studied the same tenets in lesser forums, such as on their own or at weaker schools, tend to get them almost completely wrong. If you do not understand the mathematics of Beta calculations, you might want to take Mr. Lincoln's advice when the subject comes up. Similarly, words like "hedge", "efficient markets", "information transparency", etc., have specific meanings that are not quite what the words suggest. It is important that you understand the specific meanings of numbers and formulas when you are doing valuation or else you might as well just guess. I'm about to frustrate most of the people reading this because I am going to start by giving you even more warnings about flaws as I walk through the definitions and concepts. Think of this as your lecture in shop safety - before you use the power tools make sure you aren't about to cut off your arm.
Most valuation methods are, at their core, based on DCF analysis, or discounted cash flow. Even the basic rule of thumb techniques ultimately are simply shorthand mechanisms for predicting the amount of cash that can be had through executing the processes of the analyzed business. So here come the caveats - the general case versions have way too many flaws to be taken seriously. Most of the value in DCF calculations comes from the terminal state calculations on the far right of the pro forma spreadsheets, which inevitably predict that the business will survive and prosper forever. Doesn't happen. Besides the Catholic church, name a company that's been in continuous operation for over 400 years (there are a few). OK - 20 years is generally a sufficient surrogate for forever in the calculations, but the point is that you need to understand the assumptions in order to use the generic tools. Now it is time for a reality check: do you understand discounting (if you answered 10% off at Ross - duh!, then you do not), pro forma, revenue, and profit? If you answered yes to all you also fail - seriously, what does profit mean without more context? More apologies, but before you turn on these power tools you need caution and knowledge.
If I give you a dollar now, it is worth more than if I give you a dollar next year, assuming that banks are still paying interest for savings accounts. If I offer to trade today dollars for future dollars you should accept the deal with no limit, put the today dollars in the bank, then pay me back next year and keep the interest. So the value of next year dollars is less than today dollars, and to compute how much less, I basically divide them by the interest rate I can receive on today's dollars, which is called discounting. The longer the time period, the lower the value of the future money. There are a few extremely rare exceptions - times when deflation occurs, but honestly they are rare enough and dangerous enough that you need not worry too much. (If a 1200-mile diameter meteor is about to strike the earth, you can stop worrying about the long-term impact of pesticides on your liver.) A business is basically a cash pump - you buy it or build it at a certain cost, then it pumps out money until the assets all break or are used up. Most businesses continually reinvest over their lifetimes, which makes everything more complicated. When you invest in a business or an asset you are paying a pile of today dollars in exchange for a stream of future dollars, so you value both and decide which is worth more to you. Today dollars are tangible, future dollars are speculative, so there should be an element of risk calculation in your assessment.
"Pro forma" is easy - the dollars in your pocket represent reality. The projection of what will happen after you invest them is the "pro forma" version - i.e. the analysis of the expected consequences of an investment (or any businesss action). If I have $1000 in my pocket, my current projections are that I will still have it five years from now (risk adjusted for robbery etc., it's probably worth a bit less than $1000). My current plan is to put it in the bank, so my pro forma income statement would reflect the pittance my bank would give me. If I invest it in my cousin's latest get-rich-quick scheme I will receive $300 per year for the next 4 years, then get back $1300, for a total of around $2580 (not an error - why?) future dollars, however ... (HUGE CAVEAT) ... there is only around 10% chance that this will actually happen, only a 50% chance that I will receive even the first payment, etc... so the risk adjusted future value would be around $320, which explains why I rarely invest in my cousin. If I put the money in my 401K I can expect on average to get the market return of 9%, but I have my doubts about the historical rate meaning much given the recent changes to the way that the financial markets function and are structured, so I would risk adjust that down to around 5%. In business plans you are presented with a pro forma view of the business, but like most people, you probably do not have a pro forma understanding of what happens if you do not invest, and you are even less likely to have a risk-adjusted pro forma view of both scenarios. So like everyone else, you compare tangible present dollars to intangible "wishfull thinking" dollars, neither of which reflects the truth about coming attractions.
Now on to profit... there are many different types of profit, and the one I care about is economic profit. Here are the differences: gross profit is the difference between the sales price and the cost of production of an item. If I buy a banana from Trader Joe for 19 cents and sell it for 30 cents I have a gross profit of 21 cents. If I spent 2 cents on gas, 2 cents on a telephone call to arrange the meeting, and paid myself 4 cents for labor (cost of sales not production) my profit before taxes, interest and depreciation (EBITDA) might be 13 cents. After taxes, depreciation on my car, interest on the car loan, etc., my net profit might be 3 cents. This would be pretty darned good compared to the real world - 44% Sales/EBITDA ratio, 10% Sales/Net ratio - If I compare this to an investment in Superfoods, I'd be an investor ... however ... I'm not a licensed banana seller, and I don't have a food server permit, and I left out a bunch of other stuff, so actually I am a high-risk business since I'm likely to be closed down fairly soon. Therefore, I'm entitled to more profit than a more compliant competitor. Further, it won't be long before another entrant sells bananas for a penny less, until such time as the profit stops being worth the risks - in other words competitors will drive the price down to the proper price whereat I am indifferent between the risk adjusted rewards of this business, and the risk adjusted rewards of the Superfoods business. Since the market will also drive the price of Superfoods down to the level where I am indifferent between it and an investment in CountyBank (for example), or any other company, then the excess profits will eventually be gone - i.e. unless I can constrain the market in some way, my profits are completely offset by the risks. Economic profit is the difference between the net profits and the average risk adjusted profits of a company in this industry. I want that. That means that all things considered and properly analyzed I am outperforming my alternatives. Woohoo. That kind of profit usually comes via monopoly, regulative constraint, uneven playing fields, massive size, or any of the other competitive levers you read about. It doesn't come from selling TJ bananas on the street, except maybe at midnight when TJs is closed and the regulators are asleep... and even then risk is usually correctly priced into the equation.
So let's put these ideas together - I'm thinking about buying a stable, non-growing company for $1 million which has an EBITDA of $100,000/year. I can get 4% interest from my bank, or 9% interest on average if I invest in the stock market and believe in fairies, so is it worth looking at? Corporate tax (which is different from and additive to individual income tax) is going to run around $40,000/year, so my net would be a maximum of $60,000 before accounting for risk, which puts it between the risk-free rate from the bank, and the average market rate. Since any company is intrinsically more risky than all companies collectively the market investment is preferable, so I'll pass. Get that EBITDA up to around $150,000/year and I start becoming interested - again with the caveat of the laundry list of cautions to check for. It still sucks because of the risk vectors, but it's at least becoming reasonable... i.e. I make as much as I would investing in the market as a whole. Therefore, I'm beginning to take notice of stable companies when their P/E ratio is 6.5:1 or less. If the company and/or market is declining, I need lower, and if the company and the market are growing (more or less in sync) I can tolerate a little more. How do I figure out if the market is growing and expected to keep growing? Look at the P/E for the industry as a whole - most of the time (another giant caveat) the junior, just-got-out-of-business-school analysts who compute and publish such things get the basic ratios right. In general, the bigger a company is, the less risky it's survival is, so in the case I described, I'd assess a pretty big risk factor, since a $1 million dollar company is basically an insignificant rounding error in comparison to most industries. So where do most companies sell? In or around 5:1, if the EBITDA is dependable, there are no strategic defenders of growth rates, and there are no giant gotcha's to worry about. If the company is offered at a P/E of 4:1 or less I would be darn sure to do my dilligence carefully - the incumbents know more about their company than you do, and if they are discounting it, figure out why.
Sounds easy right? Too bad it doesn't work that way. Small companies can pay their owners salary, or via dividends, or (not proper but regularly done) by paying the owner's expenses as business expenses, or in some cases, not pay the owners at all. EBITDA just doesn't translate as well as it should so we need alternate guidelines even on a high-level basis. Price to sales is another easy to compute ratio, so let's take a look at it.
Most small stable companies are valued at between one to two times their annual sales. Why? Because on average EBITDA is around 10-20% of sales, so net cashflow (assuming no debt) is around 6-12% of sales, so the company starts looking more interesting than the market as a whole at a 1.0 ratio when the margin is at the high end of that range, and at 2.0 when at the low end. Assuming a company is an average performer in its industry, it can expect an average margin, and the industry's price/sales ratio gives a good cross check for value. If I'm getting a lower ratio than the industry average, and everything looks kosher, woohoo. Again, a growing company in a growing market is entitled to a higher ratio since future cash flows should increase, and conversely, contracting companies or industries warrant (huge) discounts, or lower ratios.
What's wrong with this picture? Suppose I know I'm about to sell the company - it's time to offer discounts to all my customers to entice them to place advance orders. It'll screw my future earnings ratio, but it'll pump my current sales. If I'm smart, and not terribly ethical, I decrease my draw at the same time. This keeps my margins the same as historical averages, increase my sales, and suggests that I'm growing - all three of which look nice on the basic ratios, but it's not a sustainable situation. When I outline this in the context of a small business preparing to sell itself you might whisper "for shame" under your voice and perhaps even shake your head slightly when looking at me. Take a look at the books of banks that fail, or huge companies that suddenly file for Chapter 11 and you will see all sorts of creative techniques for painting rosy pictures in the hope that things will change for the better before anyone takes serious notice. So the caveat reads something like this: start with P/E, validate the basic calculation by taking a look at Price/Sales, then if you are still interested, go deep into the discretionary numbers to make sure they weren't rigged in a gross manner. Assuming you're still interested, throw it all away and do a real valuation since by now you should be willing to sign an NDA and get serious with the source data of the target company.
If you made it to here, you deserve a special treat, and that's what the price/employee ratio is. I care a lot about the sales/employee ratio in companies. It tells you a little about efficiency, and a lot about strategic positioning. Companies that are low-price competitors have extremely high ratios of sales to employees, whereas high-brow firms tend towards the other extreme. I expect gross margins (not EBITDA or net margins) to go in the opposite directions - order takers generate smaller margins than salesmen, but they move more product. At a minimum, this ratio can be used to cross-check the other ratios - if the company strategy is skewed one way or another from the general industry then the ratio should reflect this, and the ratio of EBITDA to gross margin should also reflect this (high-touch sales are more expensive than order taking). However, this ratio also indicates growth and performance potential of the firm - high efficiency firms are not likely to gain improved margins, but low efficiency firms with decent margins have a strong upside. Couple this to the price function, and you get a good assessment of the assets you are buying - if you are paying a lot per person, but the people are commodities in terms of function, then the price is too high. Conversely, inexpensive quality employees are a wonderful asset to discover. This ratio is not generic across industries, so there are no basic rules of thumb, but it is an easy to compute ratio that has a lot of potential to improve your understanding of the firm value, so do it.
In the next post we will dig into cash flow, which will provide support and insight into the guts of the firms and make the course estimates more meaningful.
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