In our first post we went over some of the problems Mrs. PoP and I face in valuing a small business; in this post we’ll introduce the idea of PE ratios when it comes to looking at a small business.
Long time readers know that I’m fascinated by Warren Buffett. There are lots of reasons to like the guy, (like this video…)
but one thing that I always enjoyed was how simple the explanations in his yearly letters really are. To Buffett, buying a single stock is no different than buying a piece of a larger business, and the price of the stock should be evaluated just as if you were evaluating the purchase of the entire business.
This is particularly appropriate for Buffett because of the way his career moved from buying individual stocks to buying entire businesses, but it is useful for us as well. What if we could use some of the same methods that Buffett uses to evaluate stocks to evaluate small businesses?
PE Ratio – A Quick Sorting Mechanism
Happily, we’re able to do just that with the information that the brokerage listings provide. One of the ways that Buffett, and his mentor Benjamin Graham, evaluates the intrinsic stock is through the PE ratio, or the ratio of the price of a business, divided by its earnings.
Businesses with a low PE ratio are considered inexpensive; ones with a relatively higher PE ratio are considered more expensive. Lets say you have a business that earns its owner $100,000 a year, and is also selling for $100,000; its PE would be 1. Now consider a business that earns $100,000 a year, but is selling for twice that amount; it would have a PE ratio of 2.
The PE doesn’t tell you everything. Specifically, it doesn’t tell you:
- if something is a wise investment
- if you would be better off putting your money in the market
- about the size of the businesses moat,
- or if their earnings are correctly reported.
But it does give you a high-level overview of how attractively priced a small business is in comparison to its cohort.
What About That Bakery?
Remember that bakery example from last week?
With a price of $25,000 and earnings of $49,500, this business has a PE ratio of 0.5. But does that mean it’s a good buy? The numbers seem to indicate that the business owner has an active involvement, so a purchase would garner an asset that you might expect to throw off $25K profit in year 1 after paying for the business purchase, and about $50K each year thereafter in exchange for your time. Not bad, but can we do better?
How About An Asphalt / Driveway Sealcoat Company?
This one’s got a price of $250K, and earnings of $228K, making its PE = 1.1, more than twice as high as the bakery. But does that mean it’s a worse buy? This purchase could likely also take all of your time, but the cash flow looks very different. Year 1 has a loss of $22K due to the cost of the business, then followed by $228K per year thereafter. It takes less than 2 years for this business to put more cash in your pocket overall even though both purchases are likely taking similar amounts of your time.
While the PE ratio is great, and works especially well when you’re comparing two companies in a similar industry (say a cake bakery with a pastry bakery), it’s not the whole story, so you can’t stop thinking there.
Anybody else out there wonder if they can get rich by becoming a small business magnate?
* Note from Mrs PoP – I’m pretty sure Mr PoP wants to own his own Buffett-esque empire of small businesses in our area someday. =)