Public vs private
Is buying a business the path to success?
Housekeeping: I have changed the name from Dollars and Sense to Fair Value. I wanted to expand the focus of this newsletter to things outside of just personal finance. I’ll continue to write about it, but I’ll also tackle math and computer science too. Not as an expert, but as a student. Thanks!
To summarize previous articles, it's crucial to save more than what you earn. One way to achieve this is by framing your life as a business and consider your personal profit margin, which is the percentage of your salary saved, as a primary metric for financial success. This approach shouldn’t imply that everything should mimic a business, but businesses are effective models for financial resource management decisions, and personal financial decisions which are effectively resource management problems.
Key points
You should use public market multiples to compare a purchase of a private business.
Different financial metrics of a business are valued differently between industries. Having high revenue isn’t as valuable as having high earnings.
To achieve profitability, a reverse budget or "pay yourself first" strategy can be employed. In this approach, the amount saved can be considered as profit and the day-to-day expenses of your life as business costs. Diversifying your salary or your “revenue” is essential to avoid being caught off guard in case of job loss. Purchasing a business is a viable option to diversify revenue streams, as investments in businesses typically appreciate over time through dividends that can be reinvested or capital appreciation, meaning an increase in the business's value.
Many people assume that purchasing a small business can yield more profits than investing in stocks. While this can be true depending on the circumstances, it needs to be surrounded in the context of public markets. When you invest in the stock market with your own money, you're essentially buying a business without leveraging it yourself, even though underlying businesses tend to have optimal leverage ratios. Since we tend to see the positive outcomes of owning a small business and rarely see the failures, buying a small business is subject to survivorship bias. We see the massive successes that occur that are then magnified by leverage because many people purchase or start businesses with some debt component either through an SBA loan or a loan from a bank. LendingTree estimates that 1/5 businesses fail in the first year. Compared to small businesses, public investments come with the added benefit of higher liquidity, or the ability to exit the investment easily when you want to.
One of the most challenging aspects of running a business is determining your exit strategy which is a fancy term for how you plan to sell your business. If you decide to sell a business, you may have to pay significant fees to advisors and also discount your equity when making the sale. When you invest privately, you also expose yourself to diversifiable risks unless you can purchase multiple private companies, which most people can’t do. Private investments in businesses tend to carry not only the overall market risk but also the risk that the specific company fails due to bad accounting practices, a drop in demand for a product, or costs spiraling out of control, as well as any other bad thing you can think of that can happen to a business. In markets, the amount of risk you take is typically in proportion to the amount of reward you receive. However, when you bear diversifiable risk, you aren’t actually rewarded for it, so it should be diversified away or not accepted.
You can compare owning a small business to a share of public businesses. For instance, you can use the P/E ratio for publicly available companies that operate in a similar field to the private business you are interested in purchasing. You can then compare these multiples directly to the small business you want to buy. Finviz is a useful tool that allows you to filter public companies based on their industry, geography, and other metrics. Once you have a list of public companies that are comparable to your small business, you can begin comparing employee counts, market cap (which is simply the total value of the company), among other things to find what businesses are deeply comparable to the one you’re considering purchasing.
You can easily calculate these metrics by dividing the price (market cap) by the metric (total earnings, revenue, etc., for the company). Price-to-revenue multiples may be around 2x (which means you pay $2 for every dollar of revenue the company generates), while price-to-earnings multiples may be closer to 15 or 30x. The E in P/E refers to net income and is usually the last item on the income statement. This is analogous to how much investors believe these dollars are worth today. For instance, suppose you're thinking of buying a clothing company. In that case, you can find comparable retail apparel businesses on Finviz. Below is a simple example I've created. The numbers listed below are the price (market cap) compared to the trailing twelve months of either earnings (P/E) or sales (P/S). Additionally, these values are weighted by their market cap, meaning that TJX and ROST, which handle more business and product than DLTH and EXPR, are more representative of the market. You can also weigh these figures by each company’s revenue.
Here are some comparable companies, and we can see what investors are paying for every dollar of earnings for these companies. Interestingly, you can take these ratios and find the implied profit margin by dividing the P/S multiple by the P/E multiple. So now you know a few business metrics that the market considers “efficient”. These are useful benchmarks. Here’s the math, and remember that dividing two fractions is the same as multiplying the first fraction by the reciprocal of the second fraction.
If you come across a business that's available for purchase with a better valuation multiple than what is available in the public markets, there are two narratives you can tell yourself. The first is that it's a good deal and you should go ahead and buy it, but the second is that there may be something wrong with the business for it to be offered at a discounted price. At the end of the day, this means you need to continue due diligence and determine why their financial metrics differ. You might also want to consider what would happen if the small business you're considering buying didn't have the same management team it currently has, as you would be stepping in to manage it. You could keep the existing team, but that would be an overhead cost because of their salaries, which would more closely resemble the stock market option since a management team will operate the public company on your behalf as well.
This whole process is known as comps analysis. Some business metrics are more valuable than others. For instance, revenue isn't very helpful if your cost of goods sold and overhead expenses are too high. That's why EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization, typically has a higher multiple assigned to it than revenue or operating profit. EBITDA is a useful measure of performance because it focuses on the performance of the business itself, and excludes the performance that comes from of how the business is financed or which accounting methods are used for depreciation and other sources of “financial engineering”. Another way of framing this is “If I purchase this private business outright, how much less advantageous is the stock market?”. Oftentimes, it’s not worth the risk or effort when compared to an index fund.