These two questions are asked on a regular basis. Depending on who is asking, they want me to reply, I’m seeing low numbers but we’re paying higher (for yours); or they’d like me to say, I’m seeing high numbers but we’re paying low (for ours.) I enjoy my work too much to make this my auto reply.
The more sophisticated inquirer will ask about multiples by specific businesses or by the type of business. What do you think are the right multiples for software? What about local service companies? This is a colorful lure I used to snap at. Today, all of the above forms of “what multiple” questions get a hand wave and perfunctory auto reply, “I don’t think about it like that.” Anyone that cares will immediately ask, “So, how do you think about it?” Those who want a market tip or are simply trying to make small talk will immediately change the subject. (i’ve never been known to be a great conversationalist.)
So, how do I think about it? (for those still reading.)
I believe a business has an intrinsic value. It is not perfectly knowable and is dependent upon the owner. As a result, it’s best expressed in a range. A multiple doesn’t achieve this. The range is wider for some companies than it is for others. The range is wider for all companies than it is for most bonds. But the mechanics, once some key values are established, are the same as valuing a bond. You discount future cash flows back to the net present value. I understood this at a very young age and have been learning the language and methods to improve upon the estimates ever since. The goal isn’t to nail down a perfect valuation number or even a perfect range. The goal is to get yourself to a point where you can decide to proceed –or not.
The trick to advancing a decision is thinking deeply. Multiples attempt to skip the thinking. It’s why I don’t like them.
You must estimate the future (hard) and assign a probability of that future occurring (harder.) Then, you must factor in things you can do to influence that outcome, and update your estimates as things change. This process does not have a clear ending. Given this, multiples are even more offensive to the serious business analyst and business manager.
So, do I never use multiples?
Well, I am occasionally lazy. So, yes. Sometimes, I simplify my prior research into a single multiple and use that. I’ve got a few other mental “tricks” that help me think in power-laws and adjust my multiples as expectations change. Sometimes you can memorize a probability table or certain distribution patterns for the company or industry and factor those into your thinking. These ideas can be reduced. They are out there –ideas ready to be formed. The main source is deep thought about what the business actually is and how exactly it generates results, and how that might change over time. Get your base data organized properly in your head. Then go make some huge assumptions!
Since starting Little Engine Ventures my appreciation for complex valuations has increased, backslidden, and matured –cycling through each peak to valley more than once. I have to remind myself that most of my best investments did not require a spreadsheet. They were not close calls. They were not risky (in the context of the whole) and were based on a combination of large, probable outcomes and the people involved. I have a tendency to over-weight or under-weight the influence of people. The one thing I can say for sure is the very best outcomes are so far superior to average that it is hard for people to naturally comprehend. You’ve got to think and rethink about how the nature of businesses work. What types do what things? And how? And what about the specifics of this particular business makes it special? Every business is special. Some business are just special in more valuable ways.
As a supporting argument, I believe most operating business owners have opportunities to double their money in a year presented to them every single day. The problem with most of these ideas is that they are too small to matter. Most of these ideas also require operating talent to exploit the insight in a timely manner. They disappear fast, too. Good business owners see and know their businesses very well. They see and dismiss good ideas in exchange for truly sizable opportunities. They attack certain projects with passion because they see the opportunity more clearly than anyone else. It is obvious to them and absent from others –until it’s too late.
Most investors have above average opportunities available at all times. Their primary issue is the ideas are non-obvious. You’ve got to think deeply. Perhaps it’s a real estate deal in your neighborhood. Maybe it’s owning stock in a public company that produces a product that you love and know will spread. You cannot just buy the stock because you love it, or buy and flip a house because it’s close to you, but with some reading, some thinking, some work, and some risk you may be able to own some of the companies or properties you love… and generate a profit. How cool is that?
Where is the spreadsheet? Where is the multiple?
Sometimes you need it. Sometimes the spreadsheets get huge and complicated. It often needs to get stripped down to the basics. A complex spreadsheet may or may not be a map of the actual business. A complex system, well understood, can often be reduced and remapped back to unlimited complexity. Can you reduce it? What are the basic building blocks of this company or that company? Are they the same for every business? I sure hope not. Remember, the map is not the territory. Your analysis of this or that company does not influence the company –regardless of how beautiful your analysis might be. Just because you think or want the company to sell more, trade at a higher or lower price, or cut overhead expenses as it consolidates, does not mean that it will. Furthermore, your assumptions about how management will roll out a new feature or hire new employees may be grossly different than the management’s ideas. Most managers don’t know exactly how they will handle next week, let alone several years out into an unknowable future. So, even when you know the managers it does not always go according to plan. Often times, your wishes and plans can be blurred from your reality. It can make a mess of your thinking. How then do you value it? Want to pick a multiple for all businesses? Or all industries? It’s too poor of a resolution. People are messy and outcomes are diverse.
Investment and management magic happens when you are different and right… and you size your resources to the quality of the idea. Multiples are rarely “right” and almost never different. They also don’t (or shouldn’t) form the sort of conviction that cause big action.