“The S&P 500’s current price-to-earnings ratio sits at 20.5, more than 20 percent higher than its long-term average of 15.5. Valuations are at multi-year highs, and a number of high-profile stock market darlings enjoy downright criminal valuations.”
This is an excerpt from an article I recently read on msn.com.
Why are public companies currently valued at more than 20 times earnings while the average closely-held private company typically sells between three and seven times earnings? There are several reasons:
Degree of Liquidity
A public company stock is a highly liquid investment. An investor can decide to sell tomorrow and take the cash if a better opportunity arises. Conversely, private companies are highly illiquid. It could take months, or even years, to complete a transaction.
Since there is no established market price for private companies, a great deal of negotiation has to take place between a potential buyer and a seller before they settle on a number that both parties can agree to. And if a buyer decides to back out of a transaction, the process has to begin all over again.
Balance Sheet Strength
Public companies tend to have much stronger balance sheets than their private company counterparts. One way to assess the health of a company’s balance sheet is by looking at its total liabilities-to-equity ratio. A lower number is generally desirable. For the first quarter of 2015, the average ratio for a company in the S&P 500 was 1.29. By comparison, most private companies range between 2.0 and 3.0.
Predictability of Earnings
Earnings tend to be fairly predictable and earnings data is more readily available for public companies, which equates to less risk for an investor. Because private companies are not required to disclose earnings, it is more difficult for a potential investor to gauge earnings strength.
Public companies generally have established management teams and pre-determined leadership succession plans. When a private company owner who has been active with the company for a long time decides to sell, an investor will assume extra risk. The investor will need to perform due diligence to determine whether the company has a competent management team in place that can take over for the departing owner. This team must also have solid customer relationships in order to retain them after a transaction.
Access to Capital
Public companies have much easier access to capital, and often at a lower rate. They can issue more stock to raise capital pretty quickly if necessary. If a private company needs more working capital, it typically has to contact its banker. The more capital that is needed, the greater the cost to obtain it will be.
In summary, if you are looking to sell a privately-held company, do not look at the price multiples of public companies as a benchmark since there are a number of reasons why public company multiples are much higher than private companies.
David E. Shaffer is a director with Kreischer Miller and a specialist for the Center for Private Company Excellence. Contact him at Email. See Kreischer Miller’s full list of business valuation services. Please contact us here with any specific questions you may have on this article or our valuation capabilities.
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