Mr PoP’s Thoughts on Small Business Valuations – Part 2

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
• 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.

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.  =)

37 comments to Mr PoP’s Thoughts on Small Business Valuations – Part 2

• I really want to franchise a food cart business because usually our malls here have food carts and as what I’ve seen it will make a good sale. But still I’m in the process of saving more, asking how much would be the rent and some other important details.
Clarrise @ Make Money Your Way recently posted..Cheap DIY Halloween costumes: How to Make Fairy Wings, Wand and Crown

• What kind of food carts are they?

• I may or may not have spoken with a representative from a “Doc Popcorn” franchise two weeks back. The multiples were good…don’t judge me!

• We are looking into a small biz right now – owning a concession truck for the local fairs. The numbers look really good, and potential loss is minimal, but it’s still scary to take that leap! Great post, Mr. PoP!
Laurie @thefrugalfarmer recently posted..Hidden Tips for Saving Money on Groceries

• Would you sell stuff from the farm on the truck? Integrated supply chain FTW!

• He question I have is how can you guarantee that revenues will continue at similar rates into the future. I guess that’s where the risk comes in.
Cash Rebel recently posted..How to be great at anything

• Pretty much, yeah. You can get a sense of if the owners were hiding anything, but sometimes things like regulations change. A while back “game rooms” (basically unregulated slot machine casinos) were trading at very low multiples because they were going to face new regulations in FL that would likely put them out of business.

• I love the contrasting examples. Purchasing a small business is not really something I had considered, but under the right conditions could be a pretty profitable move. I would think it might make sense to start with a smaller operation (like the bakery) even though the upside is smaller. I’m sure there are many kinks to work out in terms of making this kind of transaction work.
Matt Becker recently posted..Start Investing Now, Even if You Stink

• I dunno, think I would be a fan of the asphalt company…

Holly@ClubThrifty recently posted..Being Unemployed Sucks: What I Learned

• While we’re not averse to starting our own someday, there’s something to be said for letting someone else do all the hard work of starting something and just buying the going concern once it’s got a track record.
I guess I look at it like this: You can build a bike (or really anything) from scratch, but if you want it working for you on day 1, sometimes it’s just easier to buy it “pre-assembled” and tested out.

• Really good question! I think that there are advantages of doing it both ways, and finding a high-qualify business to buy is very difficult to do!

• CincyCat

I like how you evaluate the numbers, but as you said, they are not the sole determining factor of whether it is a good idea to buy a business. I have a ton of questions, mostly about operations. For both of these businesses, I wonder how much of the day-to-day operation is actually handled personally by the owner.

In the case of the bakery, is there a manager onsite, or is the owner the one who handles all Admin & books, etc? Are their staff bakers who come in overnight to do the baking (not unusual for this industry to do the baking in the wee hours…), or does someone in the owner’s family take care of this?

For the driveway sealcoat company, does the owner physically drive a truck & help pour the asphalt? Are there employees to be paid? How many? Are they union or at-will? What about seasonal downturns? (Admittedly, this is probably less of an issue in south Florida, but in other areas of the country, applying sealcoat is pretty much impossible under 6″ of snow.)

• CincyCat

Should read “are THERE staff bakers”, not “are their…”.

• I have a theory that unless the gross is above 200k or so, then it will be really, really tough to put a manager in and have any cash flow left over. I bet the bakery is very “hands on” for the owner, and the asphalt company might have enough cash flow to hire a manager…this is speculation of course!

• Goodness gracious… Mr. Pop, you and I are right on the same line of thinking with this! My thought? Buy small, management-in-place, operating business generating positive cash flow. Build that empire! Creates the potential to become Buffet on Main Street!

As you said in your first post, the goal is to avoid “buying a job”. Given your second example, the loss in the first year is worth the return in years 2-5, 10, 15 and on. Provided you install some sound management this could even become partially passive allowing you to leverage that cash flow (Buffet again, anyone) into additional operating businesses. LOVE this model of investing.
writing2reality recently posted..Investing with Prosper

• The asphalt business sounds great – kind of cool, too. (I remember seeing a show on American gypsies and a lot of them had this kind of business.)

Would both businesses become your full time job, or are you looking to hire someone (like the previous owner) to do the work?
Done by Forty recently posted..The Cherokee Land Lottery: What Happens When You Randomize Wealth

• I like these two posts since the Mrs. and I have thought about buying or starting a business as well. Awesome that you reference Buffett too (meet you in Omaha in May?).

Earlier this year, I met the owner of a business that I’ve always thought was a great idea; storage lockers! Here are some of the high points of our conversation:

-> He owns 3 storage locker locations. The monthly mnrtgages cost him 36K, but the lockers bring in 60K! I reapeat: 60K.

-> I then asked how many employees he had. Answer: “None, just me.” All 3 locations are on the same phone number which goes to his cell phone. The only time he ever has to do anything is when he has to meet someone to sign the storage locker contract.

-> Owners of storage lockers aren’t liable for any of the stuff people store. If you want to insure your stuff, you have to buy your own insurance. As a sidenote, he mentioned his biggest expense besides the mortgages are the property taxes.

-> He has waiting lists for all 3 locations and is trying to open a 4th to meet demand. He said they are almost always full.

-> Now, I’m saving the best for last and this is what really stuck with me. In the course of our conversation, the owner mentioned that he also flips houses. I asked him why on earth he would do that since he didn’t need the money. His answer makes me smile and really want to own a storage locker business: “This business takes such little effort and time, I needed to find other pursuits to keep me busy. I was bored.” How awesome is that? Big income with little effort!!
Mr. 1500 recently posted..Listen to this Guy!

• Ahh, in 2007 Mr PoP was obsessed with self storage units! In the recession they had some trouble around here, but a new self storage facility just went up in our town, so I presume the self storage industry is back. Personally, I dream of someday owning on-water boat storage. Have someone else pay for me to live on the water just so I can help them get their boat in the water once in a while? Yes, please!
Mrs PoP recently posted..Mr PoP’s Thoughts on Small Business Valuations – Part 2

• I am constantly astounded by the amount of crap people are happy to store in those things. Every time I think “my god, aren’t we at a saturation point?” another one seems to appear…
Mr. Pop recently posted..Mr PoP’s Thoughts on Small Business Valuations – Part 2

• Mama PoP

Yes, and Papa PoP still thinks rental storage would be a winner in your area. Maybe we will have to do it to show you kids how? Actually, I’m with Mrs. PoP on the marina and boat storage.

• My thinking is that if you can’t change them, may as well make some money off of them. Someone has to.

Big drawback to lockers are hefty startup costs. If you can get past that though…

I’m always thinking about business ideas. I’m currently ogling some multi-family buildings down the street and we’re going to look at a property in about 1 hour for a rental.

Keep us all apprised of your ideas and do let us know if you ever want an investor. Wouldn’t mind partnering up with some sharp folks. I like the was Mama PoP thinks as well.
Mr. 1500 recently posted..Thursday Rant: Solid Gold \$hit

• I wondering the same thing. Have been for quite a while :).

• I really like the idea of semi-passively buying a business. I guess its really important in these two cases to determine why the previous owner is selling. If they are willing to sell at a P/E of 0.5, then maybe something isn’t as it seems…
moneystepper.com recently posted..Real wages in the UK – how inflation is impacting your salary

• It would be so hard to evaluate how much of a profit one would make if you had to hire somebody to do what the owner is currently doing. It would also be hard to make somebody else care as much about your business as the current owner or you after purchasing it. I like the storage idea.

• I think the one thing that would hold me back on buying a small business is it would have to be something I knew how to do. I realize the goal is to buy a business to be a passive owner. If at some point though I needed to get my hands dirty, I would want to feel comfortable with what I was doing.
Micro recently posted..The Snooze Button: the silent time waster of our lifetime

• Fun analysis of PE ratios. For me, PE is a measure of risk and there’s clearly more risk with the asphalt company, so the fact that there’s also a FAR bigger reward isn’t surprising. With small businesses, the problem for me has always been transparency. Sure, there are some cool looking numbers created for the listing….but how much of that is really true? Too many small business are run on a cash basis and have unprofessional accounting methods (if that’s what they can be called at all….). So, for me, while due diligence is important, I’m doing WAY more due diligence for the asphalt company than I am for the bakery. I’m going to know everything about laying asphalt before I write that check.
AverageJoe recently posted..Have a Dream, a Plan, Whatever. But Do It. Now. Here’s Why.

• Absolutely! Mr PoP actually got pretty far along in one of the purchases that didn’t end up happening, where we signed NDAs and had meetings with the accountant that had been keeping their books for years. When the recession hit and the owners balked on seller financing, that was when Mr PoP offered to work for minimum wage to learn the ins and outs of the business to see if everyone could increase their confidence enough to close… It didn’t end up working out with that sale, but listings like these were just the very beginnings of a long DD process.

• I have toyed with the idea, especially of half automated businesses, like a laundromat, where you just have a cleaning person and collect the coins once in a while, we may build a few commercial units on our plot but I don’t think we’ll operate them, it takes a ton of time.
Pauline @RFIndependence recently posted..Why Keeping up with the Neighbors is a Bad Financial Idea

• […] Planting our Pennies: The PoPs are considering purchasing a small business, which is a really interesting concept I hadn’t given much thought to previously. Take a look at how they’re thinking about it. […]

• Wow, quite a captivating discussion and flow of ideas
The idea of being an Small Business Mogul certainly appeals to me. I’d echo Micro’s thoughts…as much as I will be the owner and not necessarily working in the business, I would certainly need to learn the ins and outs of it…it has to be something I understand…I think even Buffett advises something to that effect
Now storage lockers…that I just might try out!
Simon @ Modest Money recently posted..Crush Your Debt by Earning More