The Value Opportunity to Private Companies
Can private companies really increase their value 80-100 percent by limiting unsystematic (controllable) risks?
The November/December 2013 issue of The Value Examiner featured Ken Sanginario’s article entitled, “The Valuation Business: A Strategic Road Map for Success.” In this article, Sanginario answers questions raised by skeptics to make the case that value doubling for private companies is possible.
The November/December 2013 issue of NACVA’s bi-monthly print publication—The Value Examiner—featured my article, “The Valuation Business: A Strategic Road Map for Success,” which presented a framework to help valuators begin thinking about their practices in a different, more strategic way. The essence of the article was that valuators can also use their skills to help clients understand the opportunities to maximize future value, and identify such opportunities.
I received many favorable comments about the article, but also a few challenges about my assertion that private companies have an opportunity to increase their values by 80-100 percent by reducing the unsystematic (controllable) risks in their businesses. The challenges were not about the approach itself, but rather only about the magnitude of the opportunity. Does the notion of a doubling of value hold up in a market environment? Is there a big enough value spread among private company transactions to demonstrate that companies could double their values? What could a broad comparison to the public markets tell us?
The challenges were fair, so I decided to investigate. Here’s what I found.
I began by conducting a search of Pratt’s Stats for private company transactions within the lower middle market, using the ranges of specifications in Exhibit 1. In total, 1,500 transactions were reported, with a harmonic mean of earnings before interest, taxes, depreciation, and amortization (EBITDA) multiples totaling 5.81(which, I’ve learned, is the most appropriate measure for this type of analysis).
| Exhibit 1 | ||
| Pratt’s Stats | Low | High |
| Sales Range | $5M | $150M |
| Net Income | $0M | $50M |
| Total Assets | $0M | $100M |
| Sale Date | 1/16/1990 | 3/16/2014 |
| Enterprise Value | $1K | $100M |
| Industries | all | |
| # of Reported Transactions | 1,500 | |
| Enterprise Value-to-EBITDA | ||
| Mean | 10.91 | |
| Median | 7.39 | |
| Harmonic mean | 5.81 | |
It must be noted, however, that the Pratt’s Stats data included a very wide range of results. For the statistics experts among us, the data indicated a large standard deviation of 15.6. For the rest of us, what that means is that, in order to capture about 68 percent of the transactions in the group, we’d have to look at transactions with EBITDA multiples ranging from zero up to about 26X.
I wondered if the wide range was being skewed by certain industries, so I looked closer at the industries with five or more reported transactions. There were 87 such industries, 75 of which included transactions with EBITDA multiples greater than 10X, and 83 of which included transactions with EBITDA multiples less than 5X. So, actual transactions do support the notion that some companies (theoretically, the higher quality/lower risk companies) do transact at more than double the value of other companies in the same industry. Additionally, of the 1,500 total reported transactions, 27 percent sold for EBITDA multiples of less than 5X and 31 percent sold for EBITDA multiples of greater than 10X. So, the range of values is not isolated to only a few transactions, but is a common occurrence across most industries.
[pullquote]“…with the exception of point-in-time factors, company-specific risk is almost completely controllable.”[/pullquote]
One other point to note is that current research by Pepperdine University indicates that, during the last three years, there has been a nearly 40 percent failure rate of lower middle market companies trying to transition ownership of their companies. The single biggest reason for their failure to transact is a gap in the value expectations between buyer and seller. Those companies are not reported in Pratt’s Stats because they are valued too low to even transact. However, the opportunity for them to double in value is even more realistic than it is for the many companies that have actually transacted at low multiples.
My next approach was to compare the values from the Pratt’s Stats transactions to the values of the public market. I used the harmonic mean from the Pratt’s Stats data, keeping in mind that the range of such data could impact the comparison. By isolating the differences in value multiples between the two sources, perhaps we could identify the differences in values that are controllable by private company business owners. Below are the results of my analysis.
As of March 14, 2014, the S&P 500 was trading at a collective P/E multiple of 19.56 (Exhibit 2) which represents only its collective equity value. The overall debt-to-equity ratio of the S&P 500 totaled 0.47, meaning that the equity value must be multiplied by 1.47 to arrive at the overall enterprise value. Therefore, the enterprise value-to-earnings multiple would total 28.75.
Since most private company transactions are reported as multiples of EBITDA, rather than multiples of earnings, we need to convert the 28.75 to an EBITDA multiple. The S&P 500 collective net income margin and EBITDA margin are both reported, so we can determine that the net income margin of 2.25 percent is about half (50.56 percent) of the EBITDA margin of 4.45 percent. Therefore, the enterprise value-to-earnings multiple of 28.75 converts to an enterprise value-to-EBITDA multiple of 14.54.
| Exhibit 2 | ||
| S&P 500 | ||
| Price-to-Earnings (Equity Value) | 19.56 | as of March 14,2014 |
| Debt-to-Equity Ratio | 0.47 | source=CSIMarket.com |
| Debt-to-Earnings (Debt Value) | 9.19 | calculated as (0.47 * 19.56) |
| Enterprise Value-to-Earnings | 28.75 | calculated as (19.56 + 9.19) |
| EBITDA Margin | 4.45% | source=CSIMarket.com |
| Net Margin | 2.25% | source=CSIMarket.com |
| EBITDA to Net Conversion | 50.56% | calculated as (2.25 / 4.45) |
| Enterprise Value-to-EBITDA | 14.54 | calculated as (.5056 * 28.75) |
Next, I compared the S&P 500 and Pratt’s Stats EBITDA multiples (Exhibit 3) and isolated the differences. The most obvious difference, of course, is the fact that public company stocks are liquid, and private company stocks are less liquid. Liquidity has value and, based on various studies and court cases, I assumed that 25 percent of the S&P 500 multiple of 14.54 was attributable to its liquidity value. Eliminating that liquidity value leaves us with a value multiple of 10.91, which can be more easily compared to the Pratt’s Stats multiples.
The difference between the adjusted S&P 500 multiple of 10.91 and the Pratt’s Stats multiple of 5.81 represents the two largest risk factors that reduce the EBITDA multiples of private versus public companies, namely size premiums and company-specific risk premiums. In this analysis, the difference is an extra EBITDA multiple of 5.1, or an additional 88 percent of the Pratt’s Stats multiple of 5.81.
| Exhibit 3 | ||
| Potential Value Opportunity for Private Cos | ||
| S&P 500 EBITDA Multiple | 14.54 | |
| Estimate of Liquidity Factor | 25% | source = various pre-IPO studies |
| Equivalent EBITDA Multiple of High-Quality, Large Private Company | 10.91 | calculated as [14.54 * (1-.25)] |
| EBITDA Multiple of Lower Middle Market Private Companies | 5.81 | from Pratt’s Stats analysis |
| Private Co. EBITDA Multiple Forgone by Size And CSR | 5.10 | calculated as (10.91 – 5.81) |
| Value Difference Due to Size and CSR | 88% | calculated as (5.1 / 5.81) |
The question then becomes how much of the 5.1X multiple is represented by each of the two factors—size and company-specific risk—and how much of each is controllable by the business owner. Whatever is deemed controllable represents value that the business owner could capture through a methodical, disciplined, approach; his or her “value opportunity.”
Size Premium: The smallest of the S&P 500 companies has a market capitalization of approximately $2.8B which, according to Morningstar, would warrant a size premium of 1.75 percent (Exhibit 4), and result in a total cost of equity of 12.38 percent. Since we’re analyzing the S&P 500 as a total index, any company-specific risk would be diversified away and, therefore, there would be no company-specific risk in its cost of equity.
| Exhibit 4 | Lower Middle Market | ||
| S&P 500 | Decile 10z | Decile 10 | |
| Risk-free Rate | 3.67% | 3.67% | 3.67% |
| Equity Risk Premium | 6.96% | 6.96% | 6.96% |
| Size Premium | 1.75% | 12.12% | 5.99% |
| Total Equity Cost (excl. CSR) | 12.38% | 22.75% | 16.62% |
| Equity as a % of Capital Structure | 53.00% | 53.00% | 53.00% |
| Weighted Equity Cost | 6.56% | 12.06% | 8.81% |
| After-Tax Cost of Debt | 1.95% | 1.95% | 1.95% |
| Debt as a % of Cap. Structure | 47.00% | 47.00% | 47.00% |
| Weighted Debt Cost | 0.92% | 0.92% | 0.92% |
| Total WACC (excl. CSR) | 7.48% | 7.48% | 7.48% |
| Value difference due to Size Premium | 73% | 30% | |
Based on the S&P 500 debt-to-equity ratio of .47 and assuming the cost of debt is at prime, the S&P 500 weighted average cost of capital would total 7.48. Comparing now to the cost of capital of the Pratt’s Stats lower middle market companies, Exhibit 4 presents the impact of the range of potential Morningstar size premiums.
For analysis purposes, I’ve assumed the growth rates of the S&P 500 and the lower middle market companies to be equal. If anything, the Pratt’s Stats companies might have higher growth rates than the S&P 500 because they’re growing from smaller bases. Additionally, since 83 percent of the Pratt’s Stats companies were purchased by public companies, I’ve also assumed the capital structure, cost of debt and tax structure of the Pratt’s Stats companies to be the same as the S&P 500. Lastly, in order to isolate the impact of the size premium, I’ve initially set the company-specific risk of the Pratt’s Stats companies at zero, to be the same as the S&P 500.
Based on the assumptions described above, the difference in total cost of capital and, therefore, in value, attributable to the size premium could be as much as 73 percent and as little as 30 percent, of the total 88 percent value difference identified in Exhibit 3. Any remaining difference in value would be attributable to company-specific risk. The question of how much of a size premium is controllable by a business owner is difficult to answer because there is no empirical research that has determined the specific factors that would comprise the risk of being a smaller company. The premium has been established by analyzing the historical returns of smaller versus larger companies. However, who’s to say that a “smaller” company couldn’t operate much closer to the quality level of a larger company; in effect, playing above its size?
Logic tells us that the size premium has to do with many of the qualitative factors that are assumed to be in place and functioning in a larger company; factors such as financial stability, management depth, well-defined strategies, state-of-the-art systems, alignment of goals and objectives throughout the organization, transparency of operating results, broad customer bases, strong supply chains, and so on. During my career, I have seen small companies operate in highly disciplined, high-quality manners and have seen them sell at premium multiples. It can be done and, it is my assertion that any size premium greater than the straight 10th decile premium could be eliminated, if the business owner is determined to eliminate it.
With respect to the company-specific risk portion of the value difference, my premise is that with the exception of point-in-time factors, company-specific risk is almost completely controllable. On that basis, the owner’s value opportunity would total about 58 percent (88-30 percent), or an additional multiple of about 3X. Keeping in mind the very large range of EBITDA multiples included in the Pratt’s Stats transactions, it is not difficult to make the leap between the 58 percent controllable value opportunity calculated here, and the minimum 80 percent value opportunity that I assert is available to many lower middle market private companies, especially when you consider the natural byproduct of reducing risk is an improvement in margins and profitability, which also drives increases in value.
Clearly, a lot of assumptions are made in the above analysis, and it only reflects the public market dynamics at a single point in time. It is intended to provide some order of magnitude, rather than to be completely scientific. However, based on all the elements of the above analysis, I remain convinced that many private companies could increase their values by 80-100 percent through risk reduction programs.
Kenneth J. Sanginario, CPA/ABV, CVA, CMAP, CTP, MST, MSF, is the founder of Corporate Value Metrics (www.corporatevalue.net) and developer of the Value Opportunity Profile® (VOP®), a cloud-based application designed to help advisors to maximize the value of their private company clients. Ken has more than 30 years of experience developing value creating strategies for middle market companies in transition and is a frequent speaker at national and regional conferences.
