The concept of stock market valuation is fairly well known to most people. Most publicly traded stocks sell for a multiple of earnings. This is commonly referred to as the P/E ratio ( price to earnings ratio.) Simply put, this means that any company, be it Apple or Google or General Motors, is worth its after tax income multiplied by a valuation multiple. This is the P/E ratio.
Valuing a small business is no different. It is really a function of three numbers:
The first of these is just like the P/E ratio for a public company. Small businesses don’t trade at anywhere close to what the S&P does, but the concept is the same. A business is worth, or valued at, some multiple of its income.
The second value of a small business is a fraction of its income. Generally, this is a tool used to value private businesses and is less accurate than P/E but it is a good double check of the P/E value. It also tends to be more accurate for a young business that is still growing into its full potential. Those two numbers give you a range of values that is reasonably tight and where a business falls in the range is dependent upon circumstances.
The third value of a business is the value of its assets. If you close the doors and sell everything off, what will you get in compensation? This is almost always the lowest value.
Now back to my question. Why do small businesses sell for different prices? The answer is they have different income and sales levels. The values are consistent in that the multiples stay reasonably the same. But, the prices differ because the numbers subject to the P/E are different. This is no different than the difference in the stock price of identical company A, with an income of $1 per share, and company B, with income of $2 per share, where they both have a P/E of 3. One sells for $3 and the other sells for $6.
Small businesses of the same kind (similar industry, history, product line, risk profile, etc.) will generally have the same value multiples but different prices because of differences in performance.
