If you want to evaluate how your own business is doing, or if you’re in the market to buy another business and want to know how it’s doing, there are some especially important techniques you’ll want to be sure to use. Here’s a run down on some of the most important methodologies, many of which are used immediately prior to a merger, acquisition or other capital event.
Earnings Growth and Stability
Whether public or private, one of the most important indicators of a sound company is earnings history. The minimum standard for earnings stability is no annual earnings deficit for the trailing 5 years (better yet is no quarterly deficit in the previous 5 years). Such stability demonstrates that the company, whether small or large, has the ability to generate revenue, service its debt, and find a way to be profitable. Earnings history is one of the most important valuation tools when looking at any business in any sector.
Ideally, a business should also have rising earnings quarter-over-quarter, or at least year-over-year. The percent increase should at least match the current rate of inflation. For young growth companies on the cusp of success, the percent increase should be much higher. I’m thinking at least 10% there. For blue-chip stocks, I would want to see a 4-6% annual increase in EPS (earnings per share).
Price to Earnings
Comparing the price of a company to its earnings is a standard metric in business valuation, and for good reason. As an owner or buyer of a company, you want to have a basic idea of how much profit the company is generating for every dollar the business costs. For companies that have issued shares, this comparison can be done on a per-share basis. Small businesses without shares can have total price compared to total annual earnings. The earnings we’re talking about here are earnings after all taxes, interest, expenses, amortization, and depreciation have been considered.
For a large, publicly-traded company, a value company, I would expect to see a P/E ratio of no more than 16. For a small business with expectations of quick growth in the short term, a growth company, the P/E ratio will be much higher. Earnings haven’t taken off yet, and you’re willing to pay much more today based upon an expectation. A P/E ratio of 40 or more could be acceptable if you see a lot of potential in a small startup with good management. While these are often seen in growing public software and internet companies, they’re almost non-existent in middle-market M&A.
P/E Compared to Growth in Earnings
Comparing an entity’s P/E ratio to its growth in earnings can be a very useful tool. This is especially true for small organizations that should have significant growth in earnings. In general you want the percent growth in earnings (GIE) to exceed the P/E ratio. For example, if a business has earnings growing at 18% annually, and its P/E ratio is 17.4, you have an excellent candidate for purchase. On the other hand, if a company has a P/E ratio of 12 (sounds like a good buy maybe), but earnings are only growing at 4%, then you actually have a red flag. That company may actually be too expensive. In general, companies that have growth in earnings more than twice the value of the P/E ratio are considered outstanding, while parity generates a rating of good. A GIE to P/E ratio of less than 0.5 is a bearish indicator, especially for a growth company.
The well-known balance sheet is a must review when evaluating any business of any size. What you want to see here is a current ratio (current assets/current liabilities) of at least 1.5. If you see a company with a current ratio less than 1.5, but it has other good characteristics, such as good management, good prospects, and good cash flow, then you might still be justified in maintaining a bullish position. A current ratio less than 1.0 is a major red flag. Too much debt can destroy any business.
The all-important bottom line should not be overlooked, either. The price of the company should not more than 1.5 that of book value, or shareholders’ equity. For companies that have issued stock, this figure can be evaluated on a per-share basis. Small businesses without shares can be judged by comparing total price to total book value.
A sign of a healthy company is one that generates income for owners and shareholders. A dividend of around 2/3 of earnings is a good sign. Any business that does not issue a dividend better have a good reason not to do so. A tech startup that wants to reinvest earnings for research and development is a logical example. A large company might also elect to reinvest all earnings if it has a rational reason to do so. Before I purchased a small business or a single share of stock of a large company, I would want to see a record of consistent funds flowing to the owners, or a very good reason why that hasn’t been happening. A blue-chip company might have an uninterrupted history of dividend payments going back several decades. For a smaller company, 2-3 years of regular dividend payments is a bullish indicator.
Comparing the amount of the dividend to the price of the company is also a good metric to use. For companies that have shares trading, comparing the dividend per share to price per share is a good evaluation. Well-established companies without a rational reason to withhold a dividend should pay out at least 2% of share price annually. A small startup that needs to retain earnings to expand the business will of course pay out nothing. A large company with a dividend yield of more than 4% is a good buy.
A history of dividend increases is also a positive sign, showing the company’s ability to grow. The growth of the dividend is especially important when analyzing smaller companies. The ideal time to purchase these businesses is at the beginning of the growth period. You want to see the genesis of growth before getting in. An increase of 5% annually is the minimum for small growth companies; ideally it would be 10% or more. On the other hand, if you’re looking for a large well-established company that can offer safety and consistency, a dividend increase matching inflation would be acceptable.
Using the above valuation tools can help you analyze any business of any size. What you want to find is value and potential. Of course there are other measures and methodologies, and these are not exhaustive but general in nature, however we hope this gives you some concrete measure many analysts use to ascertain value. This is by no means exhaustive, however. A proper valuation, requires the trained eye of a trained professional.