2018 private company business valuations: historical ...… · 2018 private company business...

Prepared by

Scott Gabehart Chief Valuation Officer for BizEquity

2018 Private Company Business Valuations: Historical Trends and Future Predictions


Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 1

The BizEquity Position on Public v. Private Firm Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Public Stock Values Over Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 3 Private Firm Values Over Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 8

Gathering and Analyzing Private Transaction Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 10 Three Markets for Corporate Control. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 12 Additional Filtering Perspectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 13 Intro to Pratt’s Stats . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 14 Validity of Market Comp Data Over Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 17 Long Term Trend in Multiples by Industry Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 18 Private Buyers Versus Public Buyers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 21 The All-Important Size-Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 21 From National GDP to Industry GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 22 Effects of Reductions in Tax Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 28 Tax Cuts and P/E Ratios for Public Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 29 Tax Cuts and Economic Growth for Private Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 31

Predictions for Calendar Year 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 36 Key Macroeconomic Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 36 Merger and Acquisition Activity/Multiples Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 37


© BizEquity, LLC, 2018. All rights reserved.


Published byBizEquity, LLC

Prepared byScott Gabehart,

Chief Valuation Officer for BizEquity

INTRODUCTIONHaving valued millions of private businesses around the world going back to 2007, Bizequity has become a leading force in the democratization of business valuation information for the 98% ofbusiness owners who found it difficult if not impossible to pay the many thousands of dollars and takethe many hours and weeks required to obtain a credible estimate of their going concern value.

Based on this experience, we have developed unique and insightful perspectives relating to thehistorical trends for private firm values including techniques for estimating the collective value ofall private firms at any given point in time (the Bizequity Private Firm Index) and for estimating futuretrends in business value by industry segment or NAICS code.

Before taking a look into the future to see what is likely to transpire in terms of private firm valua-tions over the course of 2018 and beyond, it is helpful to lay out the fundamentals of valuing pri-vately-held companies and historical trends for valuation multiples by general type and size ofbusiness in the US today. Not surprisingly, it is helpful to compare such trends for private firms withtrends associated with their larger, publicly-traded counterparts.

Looking into 2018, there are five primary macro-level developments which are likely to have thegreatest impact on private company values:

Primary Macro Developments Impacting Private Company Values1. Accelerated macroeconomic growth across most sectors of US economy despite

upward trends in interest rates2. Significant decline in statutory and marginal and effective US corporate and pass-

through federal income tax rates3. Continued abatement in the prevalence and implementation of federal government

regulations of all types4. Continued acceleration of efficiencies brought on by new technology innovations in the

forms of payments; infrastructure; commerce; and front and back office advancements5. Cash-heavy corporate balance sheets and readily available debt and equity capital

facilitating national and global consolidation tendencies


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As you might imagine, each of these developments will produce favorable impacts in terms of the av-erage value of private companies operating in the US. In short, each of these factors will augmentcompany revenues, profits, profit margins and cash flows and/or stimulate the demand for busi-ness acquisitions. There are no doubt valuation risks on the horizon as well such as a military con-flict with North Korea or potential political instability in today’s environment, but the favorablesclearly outweigh the unfavorable as we head into 2018.

In addition to clarifying the often mystical realm of private firm valuation (and the differences betweenprivate and public firm valuation perspectives), this article will provide a roadmap which explains andillustrates how rising revenues, lower tax rates, lower regulations, new technology innovation andreadily available capital will offset rising interest rates to affect the average asset sale and equity val-ues for private companies economy-wide.

The Bizequity Position on Public v. Private Firm Valuation In general, it is the same “macro factors” which drive both private firm and public firm valuations overtime. It is also the case that the manner in which such firms are evaluated, valued, bought and sold isquite distinct in each of these major economic segments (apples and oranges).

One key takeaway from the Bizequity research into the evolution of private firm valuation multiples,however, is the relative lack of volatility for private company multiples as compared to their pub-licly-traded counterparts which comprise the Dow Jones Industrial Average, the S&P 500 and theRussell 2000 indices.

It is our belief that the pertinent multiples and values of smaller, privately-held and owner-operatedbusinesses simply do not rise and fall to the same degree as their public firm counterparts. Valuationmultiples for private firms are much more stable over time for similarly-sized companies in any givenindustry. The primary source of higher value and higher multiples for owner-operated companiescomes through higher revenues and higher profits and the so-called “size effect” (higher rev-enues bring higher earnings, which together bring higher multiples).

It is generally agreed that stock prices are an imperfect leading indicator of recessions andrecoveries. Determining whether sharp plunges in stock prices contain useful informationabout cyclical downturns in economic cycles or represent just noise and trading factors is a real con-cern. The business cycle—and the market, for that matter—do not always follow the rules andevery business cycle is somehow unique from all others. This is in part due to the diverse nature ofthe “bubbles” that come in various sizes and durations.

As the economist Paul Samuelson famously quipped, “The stock market has predicted nineout of the last five recessions.” But in reality, the relationship between economic cycles andstock prices is more consistent than such a comment might imply. Historically, cyclicalupswings and downswings in stock prices have almost a one-to-one correspondence with up-turns and downturns in economic growth.

Importantly, it is our strong belief that the value of the small, owner-operated businesseswhich comprise the vast majority of our index do not rise and fall in the same manner norto the same degree as the public stock marketplace. The following analysis will review and analyzethe historical changes in public and private firm valuation multiples while providing support to ourvaluation paradigm.


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Public Stock Values Over TimeAs of mid-December 2017, the various indices related to publicly-traded firms were at or near recordhighs including the prestigious Dow Jones Industrial Average (DJIA) and the S&P 500 index. At thetime of writing on December 8th, the 81st “record high” was reached by the DJIA as it closed at 24,329.

Investors are encouraged by President Trump’s tax reform plan and regulatory relief program. In addition,global growth and a weaker dollar are boosting exports at the same time that the Trump administrationis using the “bully pulpit” to encourage manufacturing firms to return to US soil. One of the key com-ponents of the tax plan is a change in the manner in which global profits for US companies are taxedwith one intended consequence being the return of all types of companies (and their financial re-sources) back into the US domestic economy. Also, foreign investors are buying U.S. stocks at the fastestrate since 2012. Consumer optimism and business optimism are at or near all-time highs, gross do-mestic product (GDP) growth has exceeded 3% for two consecutive quarters for the first time since2014 and unemployment is at a 17 year low as the economy is adding hundreds of thousands of jobsevery month.

All of these developments have helped propel the Dow to set 81 new record closing highs sincethe 2016 presidential election. For the first time ever, the Dow reached four 1,000-point milestones inone year. On January 25, 2017, the Dow hit 20,000.77 just moments after the New York StockExchange opened before closing at 20,068.51. That was just 42 trading sessions after it closedabove 19,000. That is the second-fastest rise in U.S. history. The record is the 24 sessions it took to gofrom 10,000 to 11,000 in 1999. On March 1, 2017, it closed above 21,000.

That followed a 12-day run, the longest such streak since the record 13-day stretch in 1987. When theDow breached 22,000 on August 2, 2017, it was the first time it hit three such milestones in one year.The index closed above 23,000 on October 18, 2017. Slightly more than a month later, it broke 24,000where it has since remained.


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Looking back, the Dow closed at its pre-recession all-time high of 14,164 on October 9th of 2007. Butfourth quarter gross domestic product at that time revealed a -1% contraction, announcing the startof the recession. (It was later re-estimated at a positive 2.9 percent.) The Dow then started declininggradually. After the failure of Bear Stearns in April 2008 and a negative GDP report in Q2 2008, the Dowdropped to 11,000. Many analysts felt that this 20 percent decline was the market bottom. But it was-n’t the bottom as Lehman Brothers declared bankruptcy on October 17th of 2008. Panickybankers withdrew $144 billion from money market funds the very next day, almost causing a collapse.

On September 29, 2008, the Dow fell 770 points representing the largest single-day point drop ever. In-vestors were stunned that the U.S. House of Representatives had rejected a $700 billion bailout bill tosave failing banks. The Senate reintroduced the bailout plan as “TARP” on October 3. Nevertheless,the Dow plummeted 13 percent in October. By November 20, 2008, it fell to 7,552, a new low. Thatwas still not the final market bottom. After the Dow climbed to 9,034 on January 2, 2009, itdeclined further to 6,594 on March 5, 2009.

Recent Shifts in Dow Jones Industrial Average

Timeframe Absolute and Relative Change*October of 1998 to August of 1999 Increase from 7,000 to 11,000 or 44% in 1 YearOctober of 2007 to November of 2008 Decline from 14,164 to 7,552 or 62% in 1 YearMarch of 2009 to December of 2017 Increase from 6,594 to 24,329 or 111% in 8 Years

*The percentage changes are calculated using the midrange formula, which involves dividing the change bythe average of the initial and subsequent figures, e.g. 4,000 (change) divided by 9,000 (average of 7,000 and11,000) equals 44%.

Between March of 2009 and December of 2017, the Dow has risen from 6,594 to 24,329. This repre-sents an increase of around 170% in roughly 8 years. This equates to an approximate 21% averageannual increase and a compound annual rate of growth equal to roughly 17% per annum.

Long Term Trendline for DJIA (2008 to 2017)


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The DJIA represents 30 of the largest U.S. companies spread across several sectors with the exceptionof the Transportation and Utilities sectors. The industrial and technology sectors represent the largestsector allocation of the DJIA at 20.70 percent and 16.94 percent, respectively.The DJIA experiences significant highs and lows due to geopolitical events, economic factors andstock market corrections.

Although the collective value of the indices are meaningful indicators, public firms also trade at “valu-ation multiples” including the commonly cited “price to earnings” ratio. There have been extreme pe-riods throughout the DJIA’s history that produced unusually high and low P/E readings. For example,in 1999, during the “dot.com” era, the DJIA reached a high ratio of 44.2 P/E. From 1929 to 2010,the DJIA’s average P/E was about 15. This means that investors were willing to pay, on average, $15for every $1 of earnings of the DJIA over that time span. As of December 11th, 2017, the P/E ratiowas around 21.5 times (as below):

The next table tracks the P/E ratio for the Dow Jones going back to 2007:

Year P/E Ratio* Earnings Yield Examples 2007** 16.0 6.3% 2008 13.3 (trough) 7.5% 2009 16.7 2010 13.9 2011 17.9 2012 14.2 2013 15.9 2014 16.1 2015 16.8 2016 19.4 5.1% 2017 20.1 5.0%

*Based on GAAP earnings.**The 2017 P/E ratio based on forward or expected earnings is a reasonable 17.0 times. The website www.in-vestorsfriend.com calculates that the 2017 Dow is approximately 6% over-valued despite a long run averageP/E ratio of roughly 16 times.


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Between 2012 and 2017, the average multiple paid for each dollar of earnings has risen from 14.2times to 20.1 times. This represents an approximate increase of 5.9 times or 42%. This is akin tostating that the current economic recovery has seen the average price paid for a dollar of publicfirm earnings has risen by more than 40%.

A broader gauge of public firm value would be the S&P 500, with a current P/E ratio of around 25.1times:

During the period January 1971 to June 2017, the S&P 500 P/E ratio averaged 19.4x, while the me-dian P/E ratio was 17.7x. For the majority of this period, the P/E ratio was less than the 19.4x average,as shown below.


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In fact, there were only five periods when the P/E ratio was above the average:

1. In 1987 following Black Monday, the largest one-day stock market crash in history 2. During and immediately following the early 1990s recession 3. In the late 1990s and the early 2000s, during the tech bubble, when the NASDAQ index was

trading at 600 times earnings 4. The 2008 and 2009 financial recession 5. The past 32 months. In May 2009, the P/E ratio reached a staggering 123.73x, the highest

ratio in United States history. This was primarily due to the depressed earnings duringthe “Great Recession” and has been the only instance since 1970 in which the P/E ratioreached triple digits. It is interesting to note that despite the recent runup in P/E ratios forthe S&P 500, the average ratio as of year-end 2017 remains well below the levels seen dur-ing the 1998 to 2002 timeperiod.

During the last fifteen years, with the exception of the “Great Recession,” the P/E ratio has been gen-erally centered around the average of 19.4x. Prior to 2003, there were periods where this was notthe case. From 1973 to 1985, the P/E ratio tracked close to 10x. After 1985, the P/E ratio drifted up-wards until 1992, reaching 25.93x before falling back to 14.89x in 1995.

P/E Ratios for DJIA and S&P 500 Over Time

Date S&P DJIAJan 1, 2017 23.59 20.1Jan 1, 2016 22.18 19.4Jan 1, 2015 20.02 16.8Jan 1, 2014 18.15 16.1Jan 1, 2013 17.03 15.9Jan 1, 2012 14.87 14.2Jan 1, 2011 16.30 17.9Jan 1, 2010 20.70 13.9Jan 1, 2009 70.91 16.7Jan 1, 2008 21.46 13.3Jan 1, 2007 17.36 16.0

Current Status of the S&P 500 P/E RatioThe S&P 500 P/E ratio as of June 1, 2017 was 25.7x, which is 32.47% higher than the historical aver-age of 19.4x. This ratio is in the 84th percentile of the historical distribution and was only exceededduring the early 2000s and the 2008-2009 recession. While the current P/E ratio seems to be signifi-cantly higher than average, we believe the current situation is not yet excessive to the point that itwould be called a “bubble.” As noted, the current ratio remains well below the historical highsachieved during the 1998 to 2002 tempered.

All in all, the average P/E ratio for the S&P 500 and the DJIA range between around 21 and 25 times asof December 2017. During the 2008 to 2017 timeframe (last 10 years), the DJIA and S&P 500 have beensubject to the following P/E ratio levels:


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Public Firm Valuation Multiple Variability (2008 to 2017)

Description DJIA S&P 500Range 13.3 to 21.5 14.9 to 25.7Midrange 17.4 20.3Low to High % Change 62% 72%

The past 10 years have seen the pricing of public stocks via these major indices varying by roughly60% to 75% from low to high.

Private Firm Values Over Time Although there is no ironclad relationship between any single economic variable and valuation multi-ples across industries, it is generally accepted that business values rise during economic recoveriesand decline during economic recessions. The previously presented data for public firms has beengenerally consistent with this theme. It is also the case that the average value of private firms willrise during periods of economic growth for three general reasons:

Why Do Private Firm Multiples Rise?

1) Current and expected higher revenue and higher earnings level (at any multiple) 2) The impact of the “size effect”, i.e. higher earnings warrant higher multiples 3) Rising multiples based on specific industry trends (reflecting expectations of

improving industry fundamentals over time)

As the economy transitions from recession to recovery, therefore (and vice-versa), business level rev-enues and profits rise (thereby directly increasing average business value) and eventually businesstransaction multiples also rise (thereby indirectly increasing average business value). As a compli-ment to our use of diverse market transaction databases for tracking the evolution of industry-spe-cific multiples, the Bizequity Private Firm Index will also reflect the changing industry revenuelevels which drive company size and profitability.

During the most recent business cycle starting with a recovery in 2003 and continuing through the“Great Recession” of 2009 all the way through the end of 2017, the trend of private firm median mul-tiples for all industries has clearly followed the path of the overall economy.


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GDP Data, Bizcomps and Pratt’s Stats Multiples (2003 to 2017)

Year GDP* Biz-All** PS-All2003 6.4% 1.83 4.492004 6.3% 1.89 4.242005 6.5% 1.98 4.522006 5.1% 2.00 4.642007 4.4% 2.02 4.382008 -.9% 1.83 3.132009 .1% 1.76 2.712010 4.6% 1.73 2.582011 3.6% 1.89 2.982012 3.5% 1.89 2.812013 4.6% 1.86 3.012014 2.4% 1.80 3.222015 2.6% 1.88 3.312016 1.6% 1.89 3.512017 2.5%*** 1.93 3.62

*Gross domestic product (GDP) is the value of the goods and services produced by the nation’s economy lessthe value of the goods and services used up in production. GDP is also equal to the sum of personal consump-tion expenditures, gross private domestic investment, net exports of goods and services, and governmentconsumption expenditures and gross investment. Real gross domestic product (GDP) increased at an annualrate of 3.2 percent in the third quarter of 2017 (table 1), according to the “third” estimate released by the Bu-reau of Economic Analysis. In the second quarter, real GDP increased 3.1 percent.**Through the third quarter, with the second and third quarter GDP growth rates above 3% for the first timesince 2014.***The Bizcomps multiples are based in discretionary earnings, which is equal to EBITDA plus the compensa-tion paid to a single, primary owner-operator. These multiples also EXCLUDE the value of inventory - whereasthe Pratt’s Stats multiples are based on EBITDA and INCLUDE the value of inventory.

Some key findings from these historical comparisons include:

Impact of GDP Growth on Valuation Multiples

1) The higher the GDP growth rate, the greater the rise in multiples….2) Positive GDP growth alone is not sufficient to boost multiples….3) Negative GDP growth alone is sufficient to drop multiples….

The next table compares the relative volatility in earnings multiples for public firms (DJIA and S&P500) versus private firms (Bizcomps and Pratt’s Stats) during the past 10 years:


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Public Versus Private Firm Valuation Multiple Variability (2008 to 2017)

Description DJIA S&P 500 Bizcomps Pratt’s StatsRange 13.3 to 21.5 14.9 to 25.7 1.73 to 1.93 2.71 to 3.62Midrange 17.4 20.3 1.83 3.16Low to High % Change 62% 72% 12% 33%

The preceding data confirms the Bizequity position that private firm multiples do not rise and fall aswidely (erratically) as those of the public firm cohort. One of the most impressive statistics of all withrespect to private firm valuation multiples involves the median price to revenue metric paid for all pri-vate firms by private firm buyers during the 2003 to 2017 timeperiod. During this 15 year timespan,the following statistics were gleaned:

Price to Revenue Multiple for All Private Firms (Pratt’s Stats)

Price to Revenue Range: 45% to 49%Midrange 47%Low to High % Change 9%

Surprisingly to many, the variation from low to high for average price to revenue multiples paidfor all private firms is a meager 4% in absolute terms and only 9% in relative terms. The variabil-ity in average multiples across the public and private firm cohorts is summarized here:

Average Multiple Variability (Public versus Private Companies)

Source Range Low to High Variability DJIA (P/E) 13.3 to 21.5 62% S&P 500 (P/E) 14.9 to 25.7 72% Pratt’s Stats (EBITDA) 2.71 to 3.62 33% Bizcomps (SDE) 1.73 to 1.93 12% Pratt’s Stats (revenues) 45% to 49% 9%

INTRODUCTION TO GATHERING AND ANALYZING TRANSACTION DATAWhen contemplating “trends in business valuation”, it is helpful to recognize that there are many different perspectives and data sources which can be reviewed and utilized for purposes of consulting with business-owning clients. In short, there are many different ways to gather and analyze transaction data when seeking to identify trends and pertinent valuation metrics for a giventype and size of company.


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Different Perspectives When Gathering and Analyzing Transaction Data

Two General SegmentsPrivately-owned companiesPublicly-traded companies

Three Secondary SegmentsBusiness brokerage segmentMiddle-Market segmentPublicly-Traded Companies

Myriad Tertiary or Data GroupingsThe type of companyThe industry of companyThe size of companyThe nature of transaction data resourceThe type of buyer

For example, there are two general segments, three secondary segments and myriad tertiary seg-ments or data groupings within the “market for corporate control”. Within each of these seg-ments, there are many variations and distinguishing features which must be kept in mind whenreviewing the trendline for acquisition activity and valuation multiples.

In general, the broadest classification is between privately-held companies and publicly-traded com-panies which feature the following dynamics and distinctions:

Publicly-Traded Companies1. Relative ease of access to much larger pool of relevant data2. Companies which are substantially larger3. Distortions caused by the inherent differences between publicly and closely held

companies

Privately or Closely-Held Companies 1. Limited access to less data2. Greater operational similarities with respect to size, diversification, depth of

management, access to capital, and other characteristics3. Similar ownership characteristics such as the lack of liquidity associated with not

having their ownership units freely and actively traded.

Other inherent differences exist between publicly traded and privately held companies, includingsuch factors as:

Other Differences at the Company Level1. Depth of management2. Diversification of customer base3. Geographic diversification


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4. Use of legal, accounting, and other professional counsel5. Officer compensation6. Composition of the board of directors.7. Access to capital

While this is not an exhaustive listing of differences between publicly traded and privately held com-panies, it does illustrate the unique nature of each realm. When contemplating business valuation anddeal making in general and the size premium specifically, it is necessary to think in terms of segmenta-tion (as follows). In short, the privately-held companies can be split into two subgroups referred toas “business brokerage” and “middle market” resulting in three primary “Markets for CorporateControl” as listed below:

Three Markets for Corporate Control1. Business Brokerage Segment (small, owner-dependent)2. Middle Market (medium, less owner-dependent) 3. Publicly-Traded Firms (large, non-owner-dependent)

Recognizing and understanding the presence and nature of these three markets for corporate controlis a necessary condition for properly utilizing and interpreting business valuation analyses.

As the valuation and deal making analysis moves from the business brokerage segment into themiddle market and into the publicly-traded realm, many changes unfold including:


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From Privately-Held Firms to Publicly-Traded Firms

1. The manner in which companies are sold• From “asset sale” to “stock sale,”* e.g.• From the sale of inventory, fixed assets and intangibles such as goodwill to the sale of all assets and all liabili-

ties (on and off of the balance sheet)

2. The legal and operational environment• From “compiled” to “audited” financial statements• From “owner-operated” to “board-appointed management-operated”, i.e. greater separation of “principal”

and “agent”• From unfettered decision-making to layered and decentralized management• From no/minimal public reporting to vast public reporting via SEC• From “sweat equity” and “venture capital” to common/preferred stock and “corporate bonds”

3. The methods used to value such companies• From “return on owner’s labor to “return on investment”, e.g.• From a “multiple of discretionary earnings” to “discounted cash flow analysis”, with the former INCLUDING a

single full-time owner’s compensation and the latter EXCLUDING the cost of management• From the “comparable sales method” to the “guideline public company method”

4. Pertinent discount/cap rates decline and multiples rise**, e.g.• From “1 to 3 times discretionary earnings” (business brokerage segment) to “4 to 8 times EBITDA” (middle

market transactions)to “10 to 25 times earnings” (publicly-traded stocks).

Additional “Filtering” PerspectivesMoving beyond these broad categorizations, it is also necessary to distinguish between more spe-cific classifications of market transaction data, i.e. it is essential that one clarifies and understandsthe impact of the following factors on “average” valuation multiples over time:

1. The type of company2. The industry of company3. The size of company4. The nature of transaction data resource5. The type of buyer

In short, the review of valuation multiples attributed to private company transactions requires muchmore diligence than what first might appear to be the case. Depending on a variety of factors, use ofone or more transaction databases or resources might be beneficial.

The Type of CompanyExample: Distribution versus Manufacturing versus Service versus Retail versus Non-Profit, etc.

The Industry of Company Example: Oil and gas versus software versus in-home medical care

The Size of CompanyExample: Small, owner-operated versus large, management team-led


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The Nature of the Transaction Data ResourceExample: Bizcomps (main street/asset sales) versus Pratt’s Stats (main street and middle mar-ket/asset and stock sales) versus Done Deals (large middle market/asset and stock sales) versusGF Data (growth companies/private equity and VC buyers) versus intermediary publications(major accounting firms/investment banks)

The Type of BuyerExample: Financial buyer versus strategic buyer/Private buyer versus public firm/private equityversus venture capital firm

Introduction to Pratt’s StatsAmong the various resources available for public consumption, none are more complete and robustthan Pratt’s Stats. The quarterly Pratt’s Stats Private Deal Update (PDU) provides general trend in-formation on valuation multiples and profit margins for transactions in the Pratt’s Stats database,available exclusively through Business Valuation Resources (BVR) at www.bvresources.com/prattsstats.

The PDU also includes an excerpt from the Economic Outlook Update, published by BVR.The charts and graphs in PDU present median value. The majority of valuation practitioners acceptthe median (the middle observation) as best measure of central tendency for valuation multi-ples and profit margins because outliers can distort the mean (the arithmetic average). Pratt’s Statsusers can conduct comparative analysis in the database to determine which transactions to use.

Financial advisors, merger and acquisition professionals, business appraisers, business brokers, in-vestment bankers and many others use the Pratt’s Stats database to determine the value of a subjectcompany by applying the market approach with comparable company data.

Pratt’s Stats is the premier source for private business purchase details and includes both private andpublic buyers. Pratt’s Stats includes up to 100 data points that highlight the financial and trans-actional details of the business sales. As of the publication date, the database contains 20,537 trans-actions in which the buyer was a private party. The database includes a total of 27,829 transactionsin which a privately held company was sold to either a private or public buyer.

The following tables were taken from the Pratt’s Stats Update for the 3rd Quarter of 2017, with roughly40% of the eventual final total number of 2017 transactions represented in the current year figuresshown here.

The first table highlights the long run trend in transaction price, revenue and price to revenuemultiples between 2003 and 2017. A few noteworthy findings from this first table include:

1. Note the close relationship between all of the variables below and the business cycle, i.e.the figures tend to rise and fall with the course of the business cycle, e.g. hitting a troughduring the 2008 to 2010 timeframe.

2. Note the almost shocking stability in the median price to revenue multiple for the entiredatabase (private firm buyers only, which make up the vast majority of purchasers). Dur-ing this 15 year timespan, the median multiple varied between only .44 (2009) and .49(2007). This differential of .05 represents only a 10% swing from low to high.


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When interpreting the Pratt’s Stats multiples, it is helpful to bear in mind the definition of “price” orthe “MVIC Price” (MVIC equals Market Value of Invested Capital), which is roughly comparable to “en-terprise value” (when the reported transaction is a “stock sale”) and “asset sale value” (when the re-ported transaction is an “asset sale”). The formal definition is:


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The next exhibit illustrates the diversity of the marketplace by way of key industry/business type categories:

The three largest categories (services, retail trade and manufacturing) represent morethan 75% of total transactions:

The next exhibits can be used to show the tight relationship between revenues, the median pricepaid and the median price to revenue multiple paid in any given year, i.e. as the revenue levelrises, so too do the pertinent multiples and then the average deal price. The two exhibits are lined upsuch that the timeframe of 2004 to 2017 can be visually compared. Note that as real GDP rises, sotoo do the price to revenue multiples and therefore the average price paid for a business.


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Validity of Market Comp Data Over TimeInvestor perceptions, the herd mentality, analyst expectations as to future economic and financial per-formance, supply-side economic shocks such as riots and hurricanes, etc., all serve to increase thelevel of volatility of public firm stock multiples versus private firm stock multiples.

Over the past several years (and even decades), the average small business sold across the nation waspurchased for 2.2 to 2.4 times ACF In other words, the average price to cash flow ratio (mean andmedian price) for all companies as a whole has been remarkably consistent over time throughoutthe country. Because it is only an average, many businesses sold for more than 2.3 times ACF andmany businesses sold for less than 2.3 times ACF As a ballpark estimate for the average small busi-ness, a multiple of 2 to 2.5 times ACF seems to be a good starting point for assessing company value.Stated differently, the typical small business sells for around 2.3 times ACF (with the caveat that highercash flows result in higher multiples, and vice-versa).

Raymond Miles, director of the Institute of Business Appraisers, found the same relationship be-tween average multiples over time in his analysis of the IBA Transaction Database called “Age Effects:Linear Regression of Price to Earnings Ratio on the Date of Sale for the Years 1982 Through 1991,and Linear Regression of Price to Gross Sales Ratio on the Date of Sale for the Same Years.” Heconcluded, “The price to earnings ratio and the price to gross sales ratio of closely held businessessold during the period 1982 through 1991 show essentially zero correlation with the date of sale.”Similar findings have been made by others during more recent time periods as well.

This study is very important in that it establishes that “old” transactions that occur significantly earlierthan today can be used for valuation purposes. The explanation for this is found in the relationshipbetween higher cash flow and higher multiples: As the economy grows and stock markets rise,small businesses also grow into higher production of cash flows that are rewarded with highermultiples. Thus, it is not the case that all multiples rise over time, as they do in a bull market. Rather,the company’s higher cash flows over time lead to higher multiples.

Not surprisingly, this is not the case when publicly traded guideline businesses are used underthe market approach to valuing closely held businesses. An article that appeared in Barron’s in1997 titled “The Long Stampede” indicated that the average P/E ratio for the Standard & Poor’s 500


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Stock Index increased from 7 in 1992 to 23 in 1997 (after rising further through the year 1999, thesemultiples decreased significantly in 2000 and 2001). In this case, most businesses received higher (orlower) multiples in general, regardless of cash flow levels (with the distinction being that the cashflow levels were on average several million dollars or more). This difference further highlights the sub-stantial distinctions between smaller, privately held companies and larger, publicly traded companies.

During the past roughly 18 years (1999 to 2017), the average P/E ratio for public stocks in the S&P500 has varied between 14.9 in 2012 and 46.2 in 2002. This is akin to saying that the average dollarof earnings has been worth between $15 and $46, representing a multiple of more than three from lowto high. The average multiple for private firms with revenues under $3m are likely more or lessunchanged during this same timeframe.

Historical Industry-Specific Trends in Average Market Comp MultiplesGiven the finding that the private firm multiples do not change substantially over time (rather, compa-nies grow and achieve higher multiples and values through the “size effect”), the time element doesnot appear to be as important. However, more recent comps are still preferred to less recent comps(all other things equal).

Despite the generalization concerning average multiples for all types of businesses taken as a whole,the reality is that certain types of businesses/industries do enjoy rising or falling average multi-ples over time, reflecting unique circumstances in the relevant industry. For example, privatelyowned video store multiples had fallen dramatically from their historically high levels initially becauseof the expansion of Blockbuster and other large chains and eventually due to the explosion of home-based/internet viewing opportunities such as Netflix, whereas Internet-based operations enjoyed rap-idly rising multiples in the late 1990’s and early 2000’s reflecting the spread of Internet usage andconsolidation in this industry. Most recently, the average multiple paid for general physician officeshave fallen substantially due to changes in Medicare and Medicaid reimbursements. All other factorsheld equal, more current comps are a better gauge of current value.

Long Term Trend in Multiples by Major Industry SectorThe next two exhibits for this presentation shall involve multiples presented on a major industry sec-tor basis during the 2003 to 2017 timeframe. Here are a few findings of interest:

1) During the past 15 years, the industry with the greatest volatility from low to high wasthe transportation/communications/electric/gas/sanitary segment (ranging from 1.86 in 2009 to 4.53 in 2005).

2) Some industries hit bottom before the Great Recession and others hit bottom after the Great Recession (as follows):

Hit Bottom during 2007: Construction Hit Bottom during 2009: Agriculture, Transportation, Manufacturing Hit Bottom during 2010: Retail Trade, Services, ALL INDUSTRIES Hit Bottom during 2011: Finance/Insurance, Wholesale Trade

3) Note that the average earnings multiple for “All Industries” together tracks neatlywith the business cycle, hitting bottom in 2010 and then rising steadily.

4) Between 2014 and 2017, seven of the eight industry segments have seen rising multi-ples as follows:


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Industry Segment Change in Multiple (by percent) Agriculture From 1.83 to 2.02 (increase of 10.4%) Construction From 2.16 to 2.43 (increase of 12.5%) Manufacturing From 2.62 to 2.99 (increase of 14.1%) Transportation/Comm From 2.64 to 2.51 (decrease of 4.9%)Greatest Decrease Wholesale Trade From 3.13 to 3.80 (increase of 21.4%) Retail Trade From 2.06 to 2.35 (increase of 14.1%) Finance/Insurance/R.E. From 2.51 to 2.99 (increase of 19.1%) Services From 2.11 to 2.74 (increase of 29.9%) Greatest Increase All industries From 2.21 to 2.59 (increase of 17.2%)

5) It is interesting to note that the average annual increase in SDE multiples during thepast three years of around 5.7% is VERY CLOSE to the actual increase in nominal GDPduring this same timeframe.


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Private Buyers v. Public Buyers The final exhibit taken from the current PDU will shed light on the distinction between the BusinessBrokerage Segment and the Middle Market segment (as introduced earlier). When public firms are in-volved, their target private companies are MUCH larger in terms of both revenues and earnings withcorresponding multiples between 2 and 4 times higher:

The All-Important Size-Effect This relationship is central to the BizEquity position that it is ultimately rises in GDP on an industryby industry basis which drives private firm multiples and private firm values. The so-called “sizeeffect” therefore explains much of the rising and falling of multiples among the private firm segmentversus the other often times more nebulous factors which drive public firm multiples wildly up anddown over the same timeframe.

What this means in the most practical sense is that valuation multiples paid for private firms do notrise and fall in and of themselves over time; rather, the multiples rise due to the size effect, i.e. higherrevenues and higher earnings garner higher multiples. As the economy grows, average company rev-enue and earnings grow and then pertinent multiples grow. In the most basic terms:

As GDP by industry rises or falls, average revenue by industry rises orfalls and average multiples paid by industry rise or fall.

The next exhibit provides direct evidence of the “size effect” as it pertains to the level of earn-ings and cash flow (as opposed to revenues). It is always the case that higher earnings levels willwarrant higher earnings multiples, but it is NOT always the case that higher revenues will warranthigher revenue multiples. The basic reason is that higher revenues do not always translate into higherearnings, and it is ultimately earnings which drive the value of most businesses. Some key findingsfrom the next exhibit include:

1) Between 2003 and 2017, the “size effect” in terms of multiples of discretionary earn-ings has been in force each and every year.

2) The variation in price to earnings for firms with revenue between $1m and $5m hasbeen between 2.48 times and 3.28 times with the total differential of .8 ratio for S&P500 companies dropped from 46.2 in 2002 to 14.9 in 2012, i.e. the multiple was around3.1 times higher in 2002 than in 2012.

3) Earnings multiples peaked in 2007 and hit bottom during 2009 and 2010.4) Between 2016 and 2017, the earnings multiples rose by around 2%, 7% and 6%

respectively for the three different revenue size categories tracked next:


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More About GDP: From National GDP to Industry-Specific GDPHaving established the relationship between GDP and both public and private firm valuation multi-ples, it is worthwhile to further explore the evolution of GDP over time and by industry. One of the key Bizequity valuation precepts is that a given firm’s overall value will rise as its rev-enues and profits grow. Importantly, the rise in private firm values due to higher revenues andprofits will tend to outweigh any rise in value stemming from higher average industry multiples.

For example, consider a typically-sized low middle market company with the financial statistics listedbelow. This healthy company has seen revenues and EBITDA rise by 50% and 60% respectively duringthe past four years. Based on the overall average multiples from 2014 and 2017 and the companygrowth, value has risen by nearly 80%. As illustrated here, the great majority of this increase was dueto the impact of higher earnings (60%) versus higher industry multiples (12%).

Increase in Value Due to Changing Size Versus Changing Multiples

Element Data Timeframe: 2014 to 2017 Revenue Growth: $10m to $15m EBITDA Growth $2m to $3.2m Multiple of EBITDA 3.22 to 3.62

Value in 2014 $6.44m Value in 2017 $11.58m Increase in Value 80% Increase due to Size 60% Increase due to Multiple Change 12% Increase due to Joint Impact 8%

The visualization of the impact of higher revenues on private firm value (via higher earnings) serves toemphasize the role played by industry-specific GDP growth rates on probable future company values.In order to determine which industries will feature the highest increase in value, it is helpful to identifythose industries which are expected to grow the fastest.


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For the sake of perspective, the following historical data related to GDP trends are presented:

Miscellaneous GDP Statistics

Year Real GDP # of Years to Double GDP 1948 2000 ($2 trillion) N/A 1965 4000 17 years 1987 8000 22 years 2014 16000 27 years 2044 32000 32 years? (estimate)

Peak Trough Years from Trough to Peak 1948-11-01, 1949-10-01 1953-07-01, 1954-05-01 3 years and 9 months 1957-08-01, 1958-04-01 3 years and 4 months 1960-04-01, 1961-02-01 2 years 1969-12-01, 1970-11-01 8 years and 10 months 1973-11-01, 1975-03-01 3 years 1980-01-01, 1980-07-01 4 years and 10 months 1981-07-01, 1982-11-01 1 year 1990-07-01, 1991-03-01 7 years and 8 months 2001-03-01, 2001-11-01 10 years 2007-12-01, 2009-06-01 6 years and 1 month 2017-09-30 8 years and 3 months

GDP in the United States is expected to be 19,200 USD Billion by the end of the 3rd quarter of 2017, ac-cording to Trading Economics global macro models and analysts expectations. In the long-term, theUnited States GDP is projected to trend around 20,700 USD Billion in 2020, according to their econo-metric models. Note that these projections were made PRIOR to the passing of the new tax bill inlate December of 2017.

Projected United States GDP Q4/17 3.2% Q1/18 2.7% Q2/18 2.2% Q3/18 2.1% 2020 2.0%

GDP By IndustryThe most recent recession and subsequent recovery highlighted the need for more high-quality,“real-time” information on U.S. economic performance at the industry level. While the Bureau ofEconomic Analysis’ (BEA) annual statistics on the breakout of gross domestic product (GDP) by in-dustry could be used to describe the leading contributors to business cycle dynamics, these annual


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statistics were unable to provide a timely picture of the dynamic U.S. economy as it evolves on areal-time basis from quarter to quarter - UNTIL NOW.

With a goal of providing more timely information on economic turning points, on accelerations anddeceleration in economic growth at the industry level, and on changes in industrial infrastructure,BEA issued its first “regular” release of current quarterly GDP by industry on April 25, 2014.These new, quarterly statistics—spanning the period 2005–2013—


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will now be published regularly within 30 days of BEA’s third release of GDP.Quarterly GDP by industry statistics fill an important void in U.S. federal economic statistics byproviding timely information on how individual industries contributed to U.S. economic growthin a given quarter while providing businesses with a comprehensive and consistent tool for assessing

how their industries are faring, compared with other industries.

Gross Domestic Product by Industry: Second Quarter 2017

Mining Led Growth in the Second QuarterMining; professional, scientific, and technical services; and health care and social assistancewere the leading contributors to the increase in U.S. economic growth in the second quarter of2017. According to gross domestic product (GDP) by industry statistics released by the Bureauof Economic Analysis, 17 of 22 industry groups contributed to the overall 3.1 percent in-crease in real GDP in the second quarter.


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For the mining industry, real value added—a measure of an industry’s contribution to GDP—

increased 28.6 percent in the second quarter, after increasing 12.1 percent in the first quarter.This was the largest increase since the fourth quarter of 2014 and primarily reflected increasesin both oil and gas extraction and support activities for mining.

Professional, scientific, and technical services increased 5.1 percent, after increasing 0.1percent. This was the largest increase since the third quarter of 2014.

Health care and social assistance increased 4.7 percent, after increasing 3.7 percent. Thesecond quarter growth primarily reflected an increase in ambulatory health care services.


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Other Highlights Real GDP growth increased to 3.1 percent in the second quarter, from 1.2 percent in the

first quarter. Professional, scientific, and technical services was the leading contributor to theacceleration in real GDP in the second quarter. The larger increase was primarily attributed tomiscellaneous professional, scientific, and technical services, which includes industries likespecialized design services; architectural services; and translation and interpretation services.

Retail trade increased 5.6 percent, after decreasing 0.3 percent, and was the second leadingcontributor to the acceleration.

Information services increased 7.0 percent, after increasing 1.6 percent. The second quarterincrease was primarily attributed to the broadcasting and telecommunications industry.

Gross Output by IndustryEconomy-wide, real gross output—principally a measure of an industry’s sales or receipts,which includes sales to final users in the economy (GDP) and sales to other industries (inter-mediate inputs)—increased 2.5 percent in the second quarter. This reflected an increase of3.8 percent in real gross output for the private services-producing sector and 1.3 percent forthe government sector, while the private goods-producing sector decreased 0.2 percent. Over-all, 18 of 22 industry groups contributed to the increase in real gross output.


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As discussed later, much of the forecasting related to changing company values will be based inlarge part on expectations of future industry performance metrics. Besides changes in output(revenues), changes in profitability will also drive business values throughout calendar year 2018.Leading the way in this regard is the recently passed reductions in federal corporate and personal in-come tax rates.

Service is not available everywhere. Restrictions apply.More About Tax Rates: Effects of Reductions in Effective Tax RatesThe planned tax overhaul includes components which affect both corporate entities (C-corporations)and the various “pass-through” entities (S-corporations, Partnerships, LLC’s, etc.).

Many argue that today’s public stock valuations already reflect the expectations for the tax cuts whichwere just recently finalized and signed into law. According to Stephen Gandel of Bloomberg, as muchas $11.50 of next year’s expected earnings for the S&P 500 could rely on tax cuts. Without that, profitgrowth could be much lower than expected.


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There are several ways to illustrate the potential impact of planned corporate income tax ratecuts on business value. The “bottom line” is that any reduction in the typical firm’s tax rate will en-hance its value whether it is publicly-traded or privately-held. All other things equal, a lower corpo-rate income tax rate will also encourage the use of equity financing versus debt financing due to theheightened effective cost of borrowing money (the “tax shield” of deductible interest will be lower,thereby raising the cost of debt relative to equity).

Accordingly, the primary effects of a corporate/pass-through income tax rate reduction include the following:

1. Lower tax rate leads to lower entity tax payments and higher company cash flows 2. Lower tax rate elevates the relative cost of debt versus equity, encouraging equity

financing and discouraging debt financing and reducing the overall cost of capital 3. Lower tax rate serves to mobilize the “animal spirits” made famous by John Maynard

Keynes

Tax Cuts and P/E Ratios for Publicly-Traded FirmsOpinions vary widely on the impact of tax cuts on public firm stock prices and P/E ratios. The consen-sus rightfully suggests a materially favorable impact. For example, S&P Global Market Intelligence es-timates that, in a perfect world, the impact of slashing the highest-in-the-world U.S. corporate tax ratecould be a nearly immediate 11 percent boost to the market.

The effective tax rate, or the one that companies in the S&P 500 actually pay after deductions, is 29percent, according to S&P. “The implications for stock market pricing are potentially dramatic,” S&Pstrategists said in a note.

According to what were termed “back-of-the-envelope calculations,” the ramifications go somethinglike this: Current expectations for 2017 S&P 500 earnings indicate growth of 11.8 percent, or $131 pershare. So each 1 percentage reduction in the corporate tax rate would add $1.31 to anticipated earnings.


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https://www.cnbc.com/quotes/?symbol=.SPX

https://www.cnbc.com/2016/11/30/exclusive-steve-mnuchin-no-absolute-tax-cut-for-the-upper-class.html

A 5 percent reduction would bump up earnings by $6.55, while a 10 percent cut would boost EPS by$13.09. That would translate into respective earnings gains of 17.4 percent and 23 percent. Figuringthat the index would continue to trade around 17 times the rate of earnings in the 12-month period“produces some eye-popping results.” Specifically, the 5 percent cut would generate a level of 2,340,or a 6 percent increase, while a 10 percent cut would push the index to 2,450, or 11 percent higherfrom current levels. S&P believes those levels can be achieved “sometime in the first quarter of 2017.”

Another perspective is provided by the firm Valuescope in their paper titled “The S&P 500 P/E Ratio: AHistorical Perspective”, which addresses the relationship between P/E ratios and interest rates, con-sumer sentiment and tax cuts. The following analysis is presented in terms of the tax cut impact onP/E ratios for public firms, to be followed by a different analysis pertaining to closely-held businesses.

The relationship between P/E ratios and interest rates or Consumer Sentiment is less certain whenconsidering the proposed tax cuts under the Trump Administration. While the precise effects are mud-dled due to factors such as the difference between the corporate and effective tax rate, these cuts willundoubtedly lead to an increase in after-tax earnings. Therefore, it would be reasonable to assumethat the P/E ratio, which has increased by more than two points since the 2016 election (from 23.35x to25.7x), has been influenced by this mindset. If the anticipated rise in earnings does, in fact, come tofruition from these tax cuts, then the earnings portion of the P/E ratio will be able to “catch up” and ef-fectively lower the ratio back to a more normalized level.

During the 2016 election season, Trump presented a proposal to reduce corporate taxes to a rate be-tween 15% and 20%. If such a change does occur, the effect of a lowered corporate tax could lead to adramatic increase in after-tax earnings.

However, the companies in the S&P 500 are affected by a variety of different effective tax rates. Almostall the companies measured in the index are taxed between 10% and 45% after deductions and cred-its. No sector in the S&P 500 averages an effective tax rate above 31.08%. Due to the drastic variancein tax rates, it is safe to assume that a corporate tax cut will affect all sectors in the S&P 500differently. The most recent weighted average effective tax rate for the S&P 500 as a whole was24.11%.

Despite the various effective tax rates, we can still make predictions as to how increased after-taxearnings could impact the P/E ratio. Let us first look at a scenario where all companies in the S&P 500are being taxed at 24.11% and the S&P price is equal to the value provided on June 1, 2017.8 In anideal situation, after the corporate tax cut, companies in the S&P 500 would be taxed at the given rate,and we would experience changes in the P/E ratio as described below.


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However, before Trump’s proposed corporate tax cuts, some companies were already being taxed atan average rate that was more than 10% less than the corporate tax rate after deductions. Loweringcorporate taxes to a rate between 15% and 20% could mean that companies in the S&P 500 would beaffected by even lower effective tax rates, further increasing after-tax earnings and reducing the P/Eratio.

On the other hand, if instead we look at a scenario where the P/E ratio is kept constant, we would seea noticeable increase in price as the tax rate decreased.

Is the S&P overvalued? If the tax cuts are enacted in a short timeframe, there is a reasonable basis tobelieve that P/E ratios will fall as after-tax earnings increase. However, if the tax cuts are not enacted,analysis of the historical levels of the S&P P/E ratio would suggest the market may be overvalued,indicating that prices may pull back.

Tax Cuts, Regulatory Relief and Economic Growth (Private Firms)Given the vast number of smaller private firms in the US economy and based on the general belief thatsmall private companies are responsible for most of the job creation during the past decade or longer,the impact of tax relief on these entities is likely to be greater than their public firm counterparts.

To help illustrate these scenarios, a hypothetical company from the manufacturing sector and its fi-nancial metrics shall be utilized. Assuming that 2017 has come to a close, its recent income statementresults are summarized here:

2016 2017Revenues $1,000K $1,050KGross Profits $350K $368KPretax Profits $100K $105KAfter-Tax Profits $60K $62KEBIT $120K $125KEBITDA $320K $336KDiscretionary Earnings $360K $378K


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This company is both profitable and growing with revenue, profits and cash flow increasing by 5%year over year. The effective federal and state income tax rate is a combined 40%. For the sake of dis-cussion, note that the growth in 2017 would lead to an increase in company value (all other thingsequal). Assuming that the pertinent multiple remained constant, e.g. 3 times discretionary earnings,the asset sale value would rise from around $1,080K to $1,134K or by 5%. Each additional dollar incash flow adds three dollars to company value. Besides the direct impact on value of higher earnings,the “size effect” would also lead to an increase in the pertinent multiple from say 3.0 times to 3.1times. The combined impact of higher earnings and a higher multiple raises the estimated value from$1,080K to around $1,172K (increase of $92K or close to 9%.

It is important to recognize that the preceding analysis was based on the use of discretionary earn-ings, which is a “pretax” measure of the financial resources available to a single hypothetical buyer.Use of discretionary earnings generates an estimate of “asset sale value” (not equity value), which in-corporates the value of the firm’s inventory, FF&E and all intangible assets ranging from tradename toclient list to goodwill.

Looking into 2018, a rising GDP in the firm’s target industry, e.g. manufacturing of metal widgets at thelevel of say 4% would theoretically lead to another increase in company revenues, profits and value.Let us further assume that the higher revenue level fostered a reduction in cost of goods sold from65% to only 60% (elevating the gross margin from 35% to 40%). This improvement translated into ahigher pretax profit figure of around $125K.

At the same time, let’s assume that the new tax plan coming out of Washington D.C. leads to a drop inthe combined federal and state income tax rate from 40% to only 30%. The lower tax rate and highergross profit outcome is such that the after-tax profits rise from $62K to $88K (increase of $26K ornearly 42%).

The corresponding impact of GDP growth (higher company revenues) and lower tax rates aresummarized next:

2016 2017 2018Revenues $1,000K $1,050K $1,092KGross Profits $350K $368K $437KPretax Profits $100K $105K $125KAfter-Tax Profits $60K $62K $88K*EBIT $120K $125K $145KEBITDA $320K $336K $370KDiscretionary Earnings** $360K $378K $414K

*After tax profits would be only $75K at prior higher tax rate of 40% (versus current 30%).**Equals EBITDA plus total compensation paid to a single owner-operator.


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During fiscal year 2018, the following changes unfolded:

1. Higher industry GDP led to an increase in revenues by 4%. If the company were gainingmarket share, the increase could have been as high as 6% to 8% or more.

2. Higher revenues led to higher gross profit margin and pretax profit margin 3. Higher pretax profit margin led to higher EBITDA and higher discretionary earnings 4. Higher discretionary earnings will lead to a higher asset sale value (all other things equal) 5. Higher discretionary earnings will also lead to a higher valuation multiple (all other

things equal), e.g. from 3.1 times to 3.2 times. 6. Overall, the rising industry GDP figures increase profit margins, elevate profit and discre-

tionary earnings levels and raises the pertinent multiple via “the size effect”.

And…..

1. The drop in corporate federal income tax rate from 40% to 30% led to increase in after-tax profits

2. The increase in after-tax profits will lead to a higher equity and enterprise value by wayof net cash flows to equity or net cash flows to invested capital

3. Higher net cash flows to equity or invested capital will lead to a higher capitalized valuevia the Gordon Growth model whereby:

Value = Net Cash Flows to Equity*Capitalization Rate**

*Net cash flows to equity are the preferred measure of cash flow when using discountedcash flow analysis (whether in the form of a multiple period discounting model or a sin-gle period capitalization method). Net cash flows are typically discounted or capitalizedusing a buildup model such as the Ibbotson Buildup Method. Net cash flows to equityrepresent the cash flows that are “left over” for the shareholders after the payment of allexpenses, income taxes and investments into net working capital and F,F&E. This metricis equivalent to the cash flow which drives public firm values (in the form of either divi-dends or reinvestment of cash flows into the business to elevate share price, wherebythese dividends and share price appreciation represent the “rates of return” that areused to “build up” the discount rate. The formula for net cash flows to equity and the Ib-botson Buildup rate are shown next:

Net Cash Flows to EquityNormalized After-Tax ProfitsNon-Cash Charges- Capital Expenditures+/- Increase/Decrease in Net Working Capital+/- Increase/Decrease in Outstanding LT Debt PrincipalNet Cash Flows to Equity


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Ibbotson Buildup Method One Ibbotson Buildup Method Two Risk-Free Rate 3% Risk-Free Rate Equity Risk Premium 5% + Equity Risk Premium Size Premium 7% + Size Premium Company Specific Risk Premium 4% + Industry Risk Premium Ibbotson Discount Rate 19% + Company Specific Risk Premium Ibbotson Discount Rate

**The capitalization rate used in the single period capitalization method is equal to:

cap rate = discount rate - LT growth rate

cap rate = 19% - 5% = 14%

4) The lower tax rate will increase the amount of net cash flows to equity as follows:

NCFE (original tax rate) Normalized After-Tax Profits $75K Non-Cash Charges $225K - Capital Expenditures ($248K) +/- Increase/Decrease in Net Working Capital ($4K) +/- Increase/Decrease in Outstanding LT Debt Principal $0K Net Cash Flows to Equity $248K

Value = Net Cash Flows to Equity = $248K = $1,771K Capitalization Rate** 14%

NCFE (lower tax rate) Normalized After-Tax Profits $88K Non-Cash Charges $225K - Capital Expenditures ($248K) +/- Increase/Decrease in Net Working Capital ($4K) +/- Increase/Decrease in Outstanding LT Debt Principal $0K Net Cash Flows to Equity $261K

Equity Value = Net Cash Flows to Equity = $261K = $1,864K Capitalization Rate** 14%

5) The increase in net cash flow to equity as a result of the reduction in the corporate in-come tax rate from 40% to 30% led to an increase in equity value from $1,771K to$1,864K or a rise of $93K or 5.2%.

6) The higher the normalized after-tax profit figure is relative to total net cash flows toequity, the greater the impact of a lower tax rate. For example, if the normalizedafter-tax profits rose from $750K to $880K, the net cash flows to equity would haverisen by $130K and the value would have risen by $928K, i.e. the more profitable thefirm is, the greater the impact of the lower tax rate.


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7) Based on the reasonable assumption that company revenues throughout the economywill rise by a very conservative 4%, the average asset sale value of companies will riseby around 9%.

8) Based on the reasonable assumption that the average effective corporate income taxrate (state and federal) will fall from 40% to 30%, the average equity value of compa-nies will rise by at least 5%.

9) Assuming that both assumptions hold (revenue increase of 4% and drop in tax ratefrom 40% to 30%), the average value for private companies should rise by around 15%overall.


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PREDICTIONS FOR CALENDAR YEAR 2018Having laid out the various perspectives, paradigms and valuation factors which play a role in shapingthe evolution of both public and private firm valuation multiples here in the United States, it is theproper time to conclude this Bizequity position paper with a series of predictions and projectionsfor calendar year 2018. Specifically, two different sets of predictions shall be presented which ad-dress the following key components of the market for corporate control as we enter the new year.These three categories shall be comprised of:

1. Key Macroeconomic Variables2. Merger and Acquisition Activity/Valuation Multiples

Although the predictions are broken out into two different areas, the following commentary illustratesthe mutual interdependence of the various metrics.

Key Macro VariablesAmong the many macroeconomic variables which impact overall valuation trends, the two most sig-nificant would be gross domestic product (as addressed earlier) and interest rates/monetary policy.With an expansionary fiscal policy enhanced by regulatory relief and the “bully pulpit” of Presi-dent Trump, the net impact of growth-oriented fiscal/regulatory policy versus a contractionarymonetary policy during 2018 will continue to be positive.

With GDP growth exceeding the 3% threshold for two consecutive quarters (inclusive of the impact oftwo major hurricanes), it is our belief that the next year will be one of the most memorable on recordwith annual GDP growth reaching and likely exceeding the 3.5% plateau during calendar year 2018 -despite steadily rising interest rates.

As illustrated within the analysis presented herein, rising GDP figures increase profit margins, elevateprofit and discretionary earnings levels and ultimately raise the pertinent (average) multiple via “thesize effect”.

Another favorable impact of the current fiscal policy mix results from the drop in corporate federal in-come tax rates. This will generate further increases in after-tax profits, which in turn lead to higher eq-uity and enterprise values.

In light of the new tax rates, several corporations stated that they will invest more in their U.S. opera-tions. For example, AT&T Inc. said it will invest $1 billion in the U.S., including giving 200 thousand ofits employees a $1,000 bonus. Many other firms have followed suit with the same pledge of reinvest-ing in their companies and personnel.

The new tax bill will reduce the corporate tax rate from 35 percent down to 21 percent. For private eq-uity firms, this may mean a higher return on their investments, says Nixon Peabody partner RichardLangan Jr. Industries with the highest effective tax rates are the biggest winners. Mr. Langan statedthat he believes the pharmaceutical, manufacturing and consumer sectors will benefit the most fromthe tax changes.

The cumulative impact on total private firm value will no doubt be substantial. The combination ofhigher GDP and lower corporate tax rates will impact business values through myriad channels


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and will conservatively increase private firm values by roughly 7% to 10%. Although the impactwould have been arguably greater were average valuation multiples not already at relatively high lev-els, this represents an annual rate of growth well above historical norms.

Key Bizequity TakeawayGDP growth will accelerate and push the economy towards full employmentwhile simultaneously enhancing aggregate private firm values by as much as 7%to 10% or more during 2018 as compared to 2% to 5% during the 2010 to 2017timeframe. The above average growth in company values will unfold through acombination of higher revenues/after-tax profits and higher average multiples viathe size effect and industry specific trends.

Merger and Acquisition Activity/Valuation Multiples Aggregate M&A volume in the “middle market” for the first half of 2017 was down from 2016based on a majority of available research products. Notwithstanding the decline in volume, (which re-mained at historically high levels) purchase prices are about even with last year with the averagemultiples of 10 times EBITDA for the first two quarters vs 10.3 times for FY 2016 according to in-formation published by the financial advisory firm Attract Capital.

More broadly, average middle market multiples have increased 20% since 2010, when the aver-age multiple was 8.1 times. There has been less activity in the mega-market sector with blockbusterdeal sizes, and more rotation into the middle market sector where deal sizes range from $10 million to$500 million. As larger cap market players enter the middle market, there is more competition fordeals and higher prices being paid for middle market companies. In addition, there is an abundance ofdebt players in the market looking to aggressively lend into most deals. The level of activity has cre-ated momentum in the middle market with most investment bankers and debt advisors busier thanthey have been in years. In fact, it appears that exit is on the minds of many middle market businessowners.

Among the broader universe of private firm transactions as tracked by Bizcomps and Pratt’s Stats, me-dian earnings multiples have been trending steadily upward since 2010 (as below):

Trend in Private Firm Valuation Multiples Versus GDP Growth

2010 4.6% 1.73 2.582011 3.6% 1.89 2.982012 3.5% 1.89 2.812013 4.6% 1.86 3.012014 2.4% 1.80 3.222015 2.6% 1.88 3.312016 1.6% 1.89 3.512017 2.5%*** 1.93 3.62

Between 2010 and 2017, the median multiples from Bizcomps (main street) and Pratt’s Stats (mainstreet and middle market) have risen by the following percentages:


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Trend in Private Firm Valuation Multiples Versus GDP Growth

Bizcomps Pratt’s Stats Average2010 to 2017 Total Increase in Earnings Multiples 12% 40% 26%2010 to 2017 Compound Annual Growth Rate 1.6% 5.0% 3.3%

By comparison, the average annual GDP growth rate has been around 3.2% or almost identical to theaverage increase in private company value. As expected, the average P/E ratio for the S&P 500 compa-nies rose by an even greater magnitude from 14.87 to 25.7 between 2012 and 2017, representing anapproximate 11.6% compound annual rate of growth.

Compound Annual Rates of Growth in Valuation Multiples Versus GDP

Source Annual Increase Bizcomps 1.6% Pratt’s Stats 5.0% S&P 500 11.6%

GDP 3.2%

Projected 2017 Increase 7% to 10%

According to a Citizens Bank survey more than half of the middle market is either currently involved inor open to selling in 2017. From 2016, there was an increase in selling activity. Those involved inselling rose from 10% to 16% in a year’s time and the amount of businesses open to the idea ofselling jumped from 24% to 38%. Overall, M&A receptive firms increased from 34% to 53% of themarket, which is an astonishing increase of 55%.

The November of 2017 issue of Factset Flashwire US Monthly reported that U.S. M&A deal activityincreased in October, going up 10.0% with 898 announcements compared to 816 in September.However, aggregate M&A spending decreased. In October, 6.0% less was spent on deals compared toSeptember.

Over the past 3 months, the sectors that have seen the smallest decreases in M&A deal activity,relative to the same three-month period one year ago, have been: Health Technology (107 vs. 102),Finance (369 vs. 372), Miscellaneous (11 vs. 18), Government (4 vs. 11), and Energy Minerals (50vs. 62). Only one of the 21 sectors tracked by FactSet Mergerstat posted relative gains in deal flowover the last three months compared to the same three months one year prior.

Over the past 3 months, the sectors that have seen the biggest declines in M&A deal volume, rela-tive to the same three-month period one year ago have been: Consumer Services (166 vs. 269),Commercial Services (403 vs. 496), Industrial Services (102 vs. 175), Retail Trade (76 vs. 142),and Producer Manufacturing (146 vs. 198) Nineteen of the 21 sectors tracked by FactSet Mergerstatposted negative relative losses in deal flow over the last three months compared to the same threemonths one year prior, for a combined loss of 724 deals.


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In order to learn about the hurdles M&A practitioners face when determining a valuation, Firmex, inpartnership with MergerMarket, conducted a survey of senior executives at North American in-vestment banks, private equity firms, and corporations.

Key findings in the report include:A majority of those surveyed indicate that it was either “much more difficult” (12%) or “somewhatmore difficult” (60%) to arrive at a valuation in a strategic deal rather than in a strictly financialdeal.

Dealmakers say three common biases play a role in valuation judgment: the bandwagon effect in ahot sector (68%), relying on a precedent set by a similar company, referred to as anchoring (72%), andignoring the intangibles of a target in favor of financials (72%).

Unanimously, all survey respondents say they judge whether the valuation of an acquisition wasjustified after four years or less, with 52% indicating a timeframe of three to four years.

Even as dealmakers have access to more precise data, some valuation gaps are still difficult to bridge.At least a third of those surveyed said the situation comes down to a difference in opinion regardingthe target’s potential growth. Another reason may be due to the difficulty in evaluating tangible as-sets. A managing director at a US-based PE firm explains:

“This phenomenon is most common in healthcare, manufacturing, and energy sectordeals, as the valuing of the company’s assets is a tedious task. More than the brandvalue, the valuation of the physical and intellectual assets of the company affects thevaluations greatly.”

Another complicating factor revealed by dealmakers relates to existing mental biases that can impacta target’s valuation. The most dangerous of these biases according to survey participants is ignoringthe intangibles in a deal. “Financials are important,” the managing director at a mid-market firm ex-plains, “but other important factors such as product or service mix, competition, and operationdetails get ignored, and they often make a bigger impact on the actual numbers.”

The research report indicates that the top intangible aspect dealmakers look at during valuation is thequality and fit of a target’s management team. This is echoed best from the director of M&A at a tech-nology company, who states: “We attach a lot of value to the human intellect in the organization, sinceif that aspect is present, the deal will pay great dividends.”

Private EquityDespite a challenging investment environment, Mercer Capital reports that deal flow held steady inthe second quarter of 2017 as PE firms, aided by lower high-yield credit spreads and ample powder,continued to deploy capital. Across the U.S., 866 deals were completed, totaling $151.1 billion in value.Multiples remain close to the seven-year high reached in 2016, and technology, which accounted for19% of deals through June 2017, continues to be popular.

Leverage LendingLeverage loan issuance hit a record $732 billion in the first half of 2017, surpassing the $381 billionissued in the first half of 2016 and the previous record of $660 billion reached in the first half of 2013.Refinancing activity accounted for the majority of leveraged lending at 71% of the total share, up from


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47% in the first half of 2016. New money volume increased 7% to $215 billion in the year-to-date pe-riod. New issue yields widened in June with a larger share of lower-rated credits and rising LIBOR.

Venture CapitalCapital deployment was strong in the second quarter 2017, with $21.8 billion in funding. Thisrepresents 36% growth over the first quarter of the year. However, the capital fundraising market con-tinues to exhibit heavy concentration as the number of deals closed remained relatively at comparedto the prior quarter.

Although investment pace picked up again, exit activity still lagged. The second quarter saw just 156exits, a 19% slowdown in the number of deals compared to a promising first quarter. Several high-pro-file initial public offerings spurred pushback from public investors after the companies failed to pro-duce significant returns during the first few months of trading.

The National Venture Capital Association reported that corporate venture arms accounted for $26.1billion of US venture investing through September of this year. Since the start of 2014 through thethird quarter of 2016, quarterly deal value has not been lower than $4 billion.

Catalysts for investmentAccording to PwC, these investments span many industries, including biotechnology startups, fi-nancial technology platforms, and software and IT services companies. The strategy for the invest-ments may be to acquire innovation or technology, diversify or lower spending on research anddevelopment or other operating costs, or to meet other objectives. For example, a pharmaceuticalcompany may invest in a company with a developed compound rather than increasing its own R&D todevelop the drug internally.

In SummaryDespite the clearly positive impact of the Trump administration on consumer and business optimismand the stock markets, not everyone believes that the tax reform, deregulation and other busi-ness-friendly government policies which have been touted by the Trump administration since thepresidential election will materially impact the private equity industry.

For all the headlines these topics have generated, more than half of middle-market dealmakers be-lieve these policy promises will not affect PE’s ability to raise capital, according to a survey reportedon in a Forbes article from October of 2017 by ACG New York, the largest association of middle-marketdealmaking professionals in New York. Importantly, this survey occurred prior to the actual pass-ing of tax reform.

Forbes reports that a tax restructuring — such as a reduction in the corporate tax rate or a change inthe deductibility of interest — might affect the economics of a deal or how a deal is optimally struc-tured. Deregulation could relieve reporting burdens, but these charges will be absorbed by the privateequity sector and are unlikely to materially affect how PE investors act.

“A change in the corporate tax rate might drive up valuations a little bit, but valuations are al-ready so high that people are having difficulty rationalizing the investments as they are,” accord-ing to Scott Paton (Managing Director-Sponsor Coverage Group at SunTrust Robinson Humphrey). “Itmight throw a little gas on the fire, but when the fire is already burning white hot, the incrementaltemperature difference may be indistinguishable.”


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According to the INC 5000 Fastest Growing Companies in the US 2017 list, the most successfulsmall businesses were in these fast-growth industries:

1. Travel & Hospitality – 201% aggregate growth rate2. Media – 198%3. Energy – 174%4. Security – 171%5. Real Estate – 168%

Some of the broad industry segments most likely to benefit from tax reform, a growing macroecon-omy and regulatory changes include:

Healthcare (population is aging)Construction (rising new home starts/Infrastructure bill pending)Energy (Energy Independence)Technology/Internet (Global Hegemony)

At a more micro level, Bizequity has identified a number of specific sub-industries which are likelyto feature the most significant increase in valuation multiples and cumulative value. Using a propri-etary matrix comprised of industry GDP growth rates, trends and projections; the impact of taxand regulatory reform, and select anecdotal insights, the following industries are expected to enjoyrising revenue and profit levels and improving valuation outcomes.

Wealth Management and Financial ServicesNAICS 541611 Financial Technology (Fintech) NAICS 511210, 518210, 522291, 522320, 523930, and 541511* Data&Analyitic Software and IT Consulting Firms NAICS 541512 Marijuana Farms and Dispensaries NAICS 446110, 111419, 111998, 424590,and 453998**Construction FirmsNAICS 236116, 236116, 236117 and 23621, 23622 and 2371, 2372, 2373 and 2379*** *Software publishers; Data processing, hosting, and related services; Consumerlending;Financial transactions processing; Investment advice; Custom computer programmingservices.*Pharmacies and Drug Stores, Other Food Crops, All Other Miscellaneous Crops, Other Farm ProductRaw Materials, Other Miscellaneous Stores.***New single-family housing construction, new multi-family housing construction and new hous-ing for sale builders/industrial building construction, commercial and institutional building con-struction, utility system construction, land subdivision, highway street and bridge construction andother heavy and civil engineering construction.


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Key Bizequity TakeawayThe rapidly changing macroeconomy and dealmaking environment will generatedifferent consequences depending on the company size and the industry withinwhich a given firm operates with nearly all segments benefitting during calendaryear 2018. The number of employee-driven businesses that will successfully sell(including a growing number of succession-related management buyouts) willtop the 100,000 mark making it one of the largest years ever for private companytransactions. Each of the identified industries are expected to outperform the av-erage industry segment based on the factors identified above. Importantly, theseindustries are expected to grow by an annual rate which exceeds that of overallGDP.


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2018 private company business valuations: historical ...… · 2018 private company business...

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