Fall 2002

In Business Valuation, Size Matters

Smaller entities are usually riskier than larger ones. As a result, they’re valued at smaller multiples than larger entities. That trend is clearly reflected in public company transactions. In one study of deals completed in 1999, the average P/E multiple for stock sales of $50 million or more was 22.1. By comparison, the P/E multiple for stock sales of less than $10 million was 12.7.

A key question for valuation professionals and those who rely on them, however, is whether the trend toward lower multiples continues when the companies involved are even smaller. Two recent publications offer clear evidence that it does.

Ibbotson Associates’ Stocks, Bonds, Bills and Inflation: Valuation Edition 2002 Yearbook addresses differences between the top and bottom halves of the 10th decile of public companies. Data regarding those companies shows that the trend toward higher risk and lower valuations continues even at the bottom end of the public company spectrum.

But since even companies in the bottom half of the 10th decile have values of $10 million or more, the question remains whether and to what extent a risk premium applies as a component of the cost of equity capital below that threshold.

A recent study published in Business Valuation Resources seems to provide the answer.

Going Down?

The study looked at hundreds of transactions across a broad spectrum of industries and ranked the results according to size. The largest deals studied fell between $10 million and $50 million, the middle deals fell between $10 million and $1 million, and the smallest deals were less than $1 million.

The study clearly demonstrated that multiples continue to fall with the size of the companies involved. Averaging the deal price/EBITDA multiple for the various industry groups shows a multiple of 9.45 for the largest group, 7.27 for the middle group, and 3.87 for the smallest group.

A variety of characteristics of smaller businesses increases risk and decreases value. Smaller companies find it harder to raise capital and often pay a higher cost of capital and face more restrictive covenants. They’re less diversified in both products and markets. They lack the economies of scale, distribution channels, and established vendor and customer relationships of their larger competitors. Internal controls and infrastructure are often incomplete.

In short, advisors working with small, entrepreneurial enterprises now have a wealth of evidence that, when it comes to valuations, size does matter — and the smaller a company is, the more it matters.

901 Campisi Way, Suite 250
Campbell, CA 95008
408-558-0500
info@ptlr.com

The articles in this newsletter are general in nature and are not a substitute for accounting, legal, or other professional services. We assume no liability for the reader's reliance on this information. Before implementing any of the ideas contained in this publication, consult a professional advisor to determine whether they apply to your unique circumstances.

© 2002