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A financial acquirer sees buying a business as paying today for a stream of profits in the future, which is why companies are generally bought and sold using a multiple of earnings. But focusing on your multiple is a little bit like a hypertensive person focusing on his or her blood pressure report. To really understand the number and to move it up or down, you must understand the calculations.
Buyers acquiring a company will usually do some math to figure out what they are willing to pay today for the rights to that business’s future profits.
We’ve all made a similar calculation. For example, you may have decided in the past to invest $1,000 in a bond that offers 5% interest per year; that is, you decided to spend $1,000 on something that would be worth $1,050 a year later.
To see how this math will affect the value of your business, imagine you have a company that you expect to generate $1,000,000 in pre-tax profit next year. Buyers looking for a 15% return on their money in one year, would pay $869,565 ($1,000,000 divided by 1.15) today for $1,000,000 a year from now.
When valuing a business, financial buyers will typically determine value based not only on next year’s profit but all expected profits in the foreseeable future. For every year into the future that buyers must wait to get their profits, they will “discount” the future profit that you are projecting by the rate of return they expect.
The price an investor is willing to pay for an asset relates to how risky he or she perceives the future stream of profits to be; the riskier the investment, the higher the return an investor will demand. Today, investors can put their money into relatively safe bonds and get a few percentage points of return, or they can buy a balanced portfolio of big-company stocks and expect perhaps a seven or eight percent return over time. But when buying one relatively risky business rather than a balanced portfolio, investors will expect a much higher return on their money.
Mergers and Acquisitions professionals refer to a “small company discount”, which often applies because of the perception that very small companies are riskier than larger companies. It is generally understood that larger businesses are more substantial and stable organizations because they have found a way to grow beyond the efforts of the owner(s) and are therefore less reliant on the owner(s).
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