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The Multiple in Share Valuations

Author: Des Peelo

In pursuing the task of valuation, the valuer will seek comparisons and precedents as to the multiple of profits to be used in the valuation. There will likely be few, if indeed any, comparable transactions available, particularly where the valuation of a small or medium sized company is involved. It is easier to value a large company, as there will likely be suitable comparisons available.

THE SMALL BUSINESS What is the definition of a small or medium sized company and why is it relevant to valuation? Possibly the best definition of a small business is that it does not have a management existence, or at best it has a limited existence, independent of the proprietor, proprietors or family involved.

Most small businesses have a hard working proprietor. The profits are often little more than a quasi-salary for the proprietor. There may be quirks involved, such as separate ownership of the premises, family members on the payroll, non-commercial arrangements with other family interests, and similar. One way or the other, it can be hard to get a fix on a recurring level of true profits.

If such a fix on profits (after deducting a reasonable salary for the proprietor) can be decided, it's almost impossible to find a dependable comparison on a multiple. The valuation of a small proprietor-led business is light years from a stock market multiple or the type of transaction reported in the newspapers.

Any experienced valuation practitioner will recount that proprietor-led businesses are often simply not saleable and eventually just disappear on a gradually crumbling basis until finally the proprietor falls ill or has had enough.

Many small businesses have total or almost total dependence on the skills of the proprietor, such as technical / engineering skills, the chef / proprietor of a restaurant or the buying expertise of the proprietor of a ladies fashion boutique.

There is no active market for the sale of small businesses and the belief that there is a constant hunt by active purchasers for such businesses is not true. Neither are larger companies interested in scooping up smaller businesses: it's too much trouble for the return involved, and the 'culture' of the small business is rarely compatible with a larger business.

A small business that is capable of an existence independent of the proprietor (meaning that it may be possible to replace his input with a paid manager or that it can be readily merged /added-on to another business) can likely be valued.

Experience in the marketplace suggests that small businesses, with a capability of being sold, are valued at between two-to-five times annual after-tax profits. Many small businesses cannot be sold in reality, retail businesses of all kinds (such as newsagents, small garages, take-aways, restaurants, etc) are particularly difficult to sell (mainly because banks consider them poor security). The main reason for a low multiple is risk, small businesses do not have the capacity to carry bad times, their customer base is limited and small scale in itself allows easy entry into the same business by competitors.

THE LARGE BUSINESS The larger the business, the easier it is to sell. A medium-to-large business offers more security to weather bad times, its investment in plant and machinery, working capital, etc is funded more easily by the banks, and it is more saleable in the marketplace insofar as progressive large companies have a constant eye, and the available funds, for prospective acquisitions of good size.

In valuing medium-to-large companies, comparisons with quoted companies are commonly used. However, a valuer needs to be careful that the comparison is like-to-like. In particular, the following comparisons between a private company -v- quoted company are important to note (and to be taken into account in making a private company valuation):

4 P/Es of quoted companies are based on after-tax profits. Private companies are also valued on a multiple of after-tax profits.

4 P/Es of quoted companies reflect the current purchase price of a small shareholding, a higher price would have to be paid for a large shareholding or to acquire the entire company.

4 P/Es are based on the latest publicly available results and are therefore historical. The valuation of a private company shareholding is based on a multiple related to future earnings. 4 Quoted company shares can be readily bought and sold, the same is not true for private company shareholdings. The difference is crucial and is summed up in one word: marketability.

4 No two companies are identical, and simply being in the same general business sector in itself does not mean an unqualified comparison is valid.

4 Quoted companies are generally several times larger than private companies in the same sector.

Obtaining a valid comparison between a quoted company and a private company is difficult. Rarely will such companies be comparable as to size, activities, geographical factors and so on. The Dublin stock exchange has only about 30 actively traded shares, with some sectors (banking, construction and food) having several quoted companies. The London stock exchange offers a much wider range of comparisons and, broadly, with caution can reasonably be applied in Ireland.

An overall P/E for the Dublin stock exchange on a particular date is readily obtainable from newspapers and stockbrokers (be careful as to the date, some published overall and individual P/E's are only changed once a week). That P/E will give an overall view of market sentiment as of the valuation date.

It is not scientific, (there are no published statistics or analyses), but the experience of the author and the general marketplace suggests that medium-to-large private companies (as complete entities) tend to be valued at a 30% to 40% discount on the overall quoted P/E on the Dublin stock market: even though such is not strictly like-to-like insofar as the purchase of a minority shareholding in the stock market is being compared to the value of an entire company: and the quoted P/E is historical as compared to a future P/E for the private company. Example: the overall P/E on the Dublin stock market at X date was 12.4: a 40% discount thereon would give a general P/E for private company valuations of about 7.4 times.

The Private Company Price Index (PCPI) published in the UK is derived from actual private company sales. Over the ten years 1992 - 2001, this Index showed that, on average, the P/E's achieved on private company sales were around 45% to 55% less that the average P/Es for Financial Times Index non-financial companies.

(Note that the Revenue Commissioners manual on the valuation of unquoted shares refers to 20% being the appropriate discount).

P/Es are based on multiples of after-tax profits and private company valuations (particularly small companies) are sometimes stated as multiples of pre-tax profits, perhaps because the latter is more easily understood.

A MULTIPLE COMPARISON It is not the complete picture to use an overall P/E from the stock exchange. The overall P/E is no more than a benchmark to be adjusted upward or downwards depending on the business sector in which the private company carries out its activities. A glance at P/E's of individual companies quoted on the Dublin and London stock exchanges will show variations as between different sectors.

The Financial Times provides comprehensive data including P/Es on individual companies and sectors. There is a wide range of indices available such as the FTSE 100, 250, 350, 350 Industry Sectors, AIM, Small Cap, All-Share and so on.

Overall P/E's as between particular sectors may vary widely. For instance, the construction and building materials sector is nearly always valued at lower than the overall 'norm', pharmaceuticals and biotech higher than the 'norm', and so on. Market sentiment in particular sectors can quickly react to perceived changes in economic or sectoral circumstances.

Such guidelines should not, however, be slavishly followed as clearly there will be differences when using comparisons in Ireland (such as UK retail compared to Irish retail) and such as a particular UK sector being dominated by one or two giant companies.

There may also be a comparison available through an Irish quoted company, (even if only as a general comparison), or possibly through a recent publicly known sale of a similar private company in the same sector. Following a review as per all of the foregoing, a reasoned multiple is chosen by the valuer.

There are other aspects re understanding the use of a multiple in valuations. It should not be overlooked that investment in equity, (ie shares in a company) carries risk, particularly in private and / or small enterprises. It is not uncommon for all such investment to be lost or diminished in value. For this reason, the market (ie, investors) demands an above average return on the investment to compensate for this risk, hence small and medium sized private companies will invariably attract low multiples, unless there are compelling growth prospects.

The selection of a particular multiple happens through the valuer ascertaining relevant marketplace values, the stock exchange being the common source for large companies. In using such comparisons, a wary valuer should recognise that it is not always the case that what happens on the stock exchange can be seamlessly and unthinkingly translated to the valuation of private companies.

Des Peelo has specialised in business and share valuations for more than thirty years and recently published a book on the topic. This is the second in a series of 3 articles. In our next issue, Mr Peelo considers Shareholders’ Agreements.

The Multiple in Share Valuations

Author: Des Peelo

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