Often I find myself discussing valuation with private business owners and many times they will bring up market multiples of their larger, public competitors as a point of reference. Unfortunately, this often provides an unrealistic view of value for their smaller, middle-market business as private companies have an inherent liquidity discount that public companies do not have.
Public companies also have the benefit of size and scale which contributes to higher valuation multiples. Other attributes like the ability to buy and sell shares in the open market and raise capital through equity offerings further support these valuation premiums.
While public companies have the benefit of size and scale, they do provide a good proxy for industry performance and growth. I often use these proxies when discussing the market with the business owner. If the public competitor is growing revenues at 20% with 15% EBITDA (earnings before interest and depreciation and amortization) margins and the target company is growing at half that rate with lower margins, it often becomes clear to the owner that his valuation anchor is too high.
This is not to say that all smaller businesses should trade at a discount to their larger pubic competitor. Many companies can and do trade at a premium, due to some competitive strength such as a proprietary product line or market position. The more strategic and the more accretive to the buyer to more likely the seller will achieve a premium valuation.
Valuing a business is very subjective and involves many factors such as historical and future performance, product and customer mix, end-markets and distribution channels. I find the valuation process to be more of an art than a science because there are some many factors that can potentially affect the valuation, both good and bad. Public company multiple can serve as a valuation proxy, but comparable market transactions as well as a discounted cash flow analysis will help in formulating a fair and comprehensive valuation.