The multiple -- the P/E ratio -- is indicative of the market's sentiment towards the future prospects of the company. If we take efficient market theory as gospel, then the earnings multiple reflects perfect information as an input to the market's view of the future prospects.
In a closely held small business, the earnings are known, but the market multiplier is not. Therefore a proxy is used. The proxy should be the most similar firm for which a multiple is publicly available.
The main advantage of this approach is that it is simple. There are only two variables and if a reasonable proxy can be found, then the result should also be reasonable. However, it is difficult to find suitable proxies for small businesses. Most publicly traded firms are not small businesses. With different operations metrics, economies of scale, histories and competencies, even a medium-sized firm in the same industry may make a poor proxy. Moreover, it is difficult to evaluate many small businesses because the value of the goodwill and owner's expertise is difficult to discern. These factors are likely stronger in a small closely-held business than in a larger, public firm.
Thus, the simplicity of the earnings multiplier approach is one of its main drawbacks. It relies too much on the assumption that a reasonable proxy can be found. If the firm is large enough, this may be the case, but clearly there will be times when this approach is next to useless because the best available proxy is too distant from the firm subject to purchase.
Capitalized Earnings Approach
The capitalized earnings approach equates the value of the business to a return on investment. The new owner will demand a return on investment that is commensurate with the risk of the company. In order to justify purchase, the prospective new owner must feel that it can either increase the profits or lower the risk (Valuations LLC, 2009).
In order to use this approach to value a business, the prospective owner must determine the risk level for the company. This risk level will then be equated to a return that is necessary to justify the risk. Thus, the company is compared to other investments of similar risk level.
The main advantage of this technique is that it reflects the underlying principle that investment decisions are not made in vacuums. There is frequently a trade off -- to purchase the company means forgoing an investment elsewhere. Thus, the risk level of the company dictates its value. If the asking price for the company exceeds that which is considered a reasonable return for the risk, then the prospective buyer will walk away, either to hold their money or to make a different purchase that offers a higher ROI for the same level of risk.
There are a couple of main disadvantages to using this technique. One is that the risk levels and ROI are both based on historical information. This means that there is an overreliance on past performance as an indicator of future performance. In many cases this is not true even if the purchaser did nothing with their acquisition. It is more likely, however, that the purchase will do something with the acquisition in order to derive greater value. Thus, the capitalized earnings approach does not reflect the value of the business going forward. Remember that the current ownership group is going to look at the value of their business on a going forward basis -- they have their own plans for improving performance. It may be more difficult to find an adequate price point if this method is used that will compel the existing ownership group to sell.
Basis for Commonly Applied Premiums and Discounts
The two most basic forms of deriving these assumptions are through the interpretation of the acquisition target's operations and the use of proxies. The former is complicated. The different models and approaches discussed above are in part derived as a means to work around the difficulties inherent in analyzing the operations of closely-held small companies. The models move away from intense analysis to differing degrees, but each recognizes the inherent problems in deriving premiums and discounts by that means.
However, by using methods that rely on direct analysis to derive premiums and discounts, it forces the prospective purchaser to learn more about the firm they intend to purchase. This has inherent advantages -- the more you know, the better the interpretation of that information will be. Prospective purchasers can better understand not only what the true value of the firm is but what the true value of the firm will be post-purchase. This underlying basis for deriving premiums and discounts should, if the acquisition target is even remotely co-operative, yield better results. If the acquisition firm is not cooperative, that is when proxies come into play.
Proxies are inherently weak as a means of deriving premiums and discounts. It is rare that two firms will share such similar operations, histories, strengths and weaknesses as to be directly comparable. However, there may be times when the availability of hard facts about the acquisition target is so poor that a proxy gives a better sense than the information actually available. The basis for proxies is that like firms tend to be highly correlated. Finding a proxy does therefore involve enough analysis to determine if a firm is similar enough to be an appropriate proxy. This may not be a strong basis for analysis, but it is useful tool in lieu of direct access to information from the acquisition target.
There are inherent risks with respect to overreliance on proxies. As useful as they can be, they are subject to their own assumptions. The choice of a proxy will be made based on decisions regarding the best criteria for deciding the best proxy. This added layer of complexity brings the output further from the desired output, because the input (the proxy) is inherently further from the actual input (the acquisition target). Of critical importance is the fact that the value the prospective buyer places on the acquisition target is based on what it thinks it can do with the target, not what it thinks it can do with the target's most closely-structure competitor. That extra degree of separation should be understood for what it is, and proper heed taken that the results will be weaker because of it.
It is crucial for firms looking to purchase a closely-held small business to ascertain fair value for the firm. There are different methods, based on different underlying principles, to attain such a valuation. All methods look to the past to some degree as an indicator of future performance. Each method does this to varying degrees -- some remain highly focused on past results or present circumstances.
There are therefore a wide range of different options -- from discounted cash flows to net asset approaches; from earnings multipliers to capitalized earnings approaches. Each method has advantages and disadvantages -- firms need to consider these before settling on an approach. It may even be wise to utilize multiple approaches, as a stress test of management's findings.
One thing that is common for each valuation method is that it will not give the same valuation as the methods used by the ownership of the acquisition target. The market for closely-held small businesses is not efficient -- there is no perfect information for outsiders. The more the prospective purchaser can become an insider and get the knowledge from within the target company, the stronger will be their assumptions and the more accurate will be their valuation.
Fair value naturally represents one step in the process. Given that the purchasing firm must then determine if they can derive more value than currently exists, fair value is the logical starting point for the bid process. This makes accurate determination of fair value critical. The process is thus driven by the strength of the underlying assumptions in all cases. Attention to these will yield better results, but gathering information so that fewer assumptions are required will yield the most robust valuations of all.
No author. (2009). Small Business Valuation Methods. Valueline. Retrieved April 29, 2009 from http://www.ventureline.com/techniques.asp
Laro, David & Pratt, Shannon B. (2005). Business Valuation and Taxes: Procedure, Law and Perspective. Retrieved April 29, 2009 from http://books.google.com/books?id=b-nUUYzoCS0C&pg=PA260&lpg=PA260&dq=net+asset+approach&source=bl&ots=mL_5DzT3XP&sig=-ch6njeF0VkiLL4HSbxrUMVksLg&hl=en&ei=jor4Sd2xFcintgfav6C8Aw&sa=X&oi=book_result&ct=result&resnum=9
No author. (2009). Capitalized Earning Approach. Valuations LLC. Retrieved April 29, 2009 from http://guidetosellingabusiness.com/Valuing-the-business/Capitalized-Earnings-Approach.php