I hear lots of interesting observations and questions about the value of businesses. Recently a business owner said to me, “Peet’s Coffee, (Nasdaq: PEET) trades for 20 times earnings, so should I be able to sell my Mike’s Coffee Emporium for that?” It’s a great question. Besides brand recognition and the liquidity of public vs. private company shares, size is the obvious difference between Peet’s and Mike’s. So how much does the size of a company and its earnings affect valuation multiples? Quite a lot as it turns out. On average, larger companies tend to sell at higher multiples of most financial measures than smaller companies in the same industry. Conversely, the smaller the company, the lower the average market valuation multiple.
When you look at the public markets you see that companies under $50 million revenue typically sell for considerably lower price-to-earnings multiples than companies from $50 to $500 million, and companies over $500 million typically sell for higher multiples than those from $50 to $500 million. According to business valuation expert Shannon Pratt, who has authored numerous seminal works and is widely recognized as the father of privately held business valuation, “Larger companies are less risky, and therefore, are priced in the market reflecting lower discount rates and higher market multiples.”
Middle Market companies with $1 to 5 million of EBITDA (normalized annual earnings before interest, taxes, depreciation and amortization) are also more marketable, involve less risk, are more readily financed and command higher price multiples on average than companies with less than $1 million EBITDA.
This difference holds true for smaller “Main Street” businesses as well. The following table illustrates the relationship between two price multiples and company revenues, using data from a study of thousands of small-business sales across all industries:
Size of Company Sale Price / Revenue Sale Price / Discretionary Earnings*
Up to $1 million revenue 0.51 2.2
$1 to 5 million revenue 0.62 2.9
* Discretionary Earnings is equal to EBITDA plus reasonable compensation to a general manager (usually the business owner). It is interesting to note that in many of the very small business transactions, EBITDA is actually zero or negative, and should not be used as a basis of comparison. The purchaser essentially buys a job.
Since size does affect business value, market data used to estimate the value of your company should be limited to an appropriate size range. Using prior transaction data or indirect industry rules of thumb derived from companies that are much larger or smaller than your company can result in incorrect conclusions about business value.
So what’s at stake?
Errors in business valuation can lead to poor decisions about buying, selling, merging, gifting, tax planning, investing in or loaning money to a business. If you’re selling for example, you risk undervaluing your business and leaving hard-earned money on the table, or you risk overpricing it and wasting precious time and resources and experiencing undue market exposure and potential loss of confidentiality. For the small business owner, when making important decisions involving your life’s work and perhaps your most valuable asset, it makes sense to value it right the first time.
About The Author: Al Statz is a Certified Business Intermediary (IBBA) based in Sonoma County, specializing in confidential business sales, valuations and exit strategies. You can reach Al at 707-778-2040.