Private businesses need to understand their firm’s valuation to quality for growth funding. Price-to-earnings (P/E) ratios vary widely between sectors and companies. Tech firms often trade at 30x earnings, while utilities hover near 10x. Why? How is it relevant to private businesses? Let’s decode the role of dividends, business risk, and banchmarking, in shaping the valuation of your business.
This article is a high-level introduction to P/E ratios and business valuation. It is not business or investment advice. Always consult a financial expert to address your unique circumstances.
Key Concepts in Business Valuation
1. P/E Ratios: The Basics
The P/E ratio divides a stock’s price by its earnings per share (EPS). High P/E ratios signal growth expectations. Low P/Es may mean undervaluation or risks.
Example:
Tesla’s P/E of 1900x (Nov-2021) reflects bets on EV dominance. Westpac Bank’s 15x P/E (Nov-21) mirrors steady, slower growth.
2. Stock Splits: Math vs. Perception
A stock split (e.g., 2:1) splits shares into smaller units. Here’s why P/E stays the same:
- Share Price Halves: A 50 stock holding becomes 100.
- EPS Halves: Earnings spread over double the shares.
- P/E Ratio: (50÷50÷0.50 EPS) = 100x. Same as (100÷100÷1 EPS).
Why Split?
Splits boost liquidity and attract small investors. Apple’s 2020 4:1 split didn’t change its P/E but made shares more accessible.
3. Dividends vs. Reinvestment
- Dividend Stocks: Pay cash to shareholders (e.g., banks). Attract income-focused investors but may limit growth capital.
- Growth Stocks: Reinvest profits (e.g., Amazon). No dividends, but higher valuations from expansion potential.
Most listed Australian companies pay dividends however this is not the predominant case in the US.
Example:
Microsoft pays modest dividends (0.8% yield) but invests heavily in AI, driving its P/E to 35x. Warren Buffett believes retained earnings can generate higher returns for shareholders when reinvested into the business (e.g., acquisitions, R&D). He says Dividends are taxed immediately. By retaining earnings, shareholders defer taxes until they sell appreciated shares. For Berkshire, holding cash allows them to seize opportunities (e.g., buying companies during crises).
4. Sector Valuation Differences in P/E Ratios
- Tech: High P/E (growth focus).
- Utilities: Low P/E (stable, slow growth).
- Cyclicals (e.g., mining): P/E swings with economic cycles.
Case Study:
During the 2022 tech slump, Meta’s P/E dropped from 30x to a low of 6.6x as ad revenue slowed. In Jan 2020 at the commencement of the COVID19 pandemic, Meta’s earnings per share was $2.56 and the P/E was 29x. By Jan 2023 full-year EPS was $8.59 and P/E was 11x after reaching 43x in Jan of 2021. A volatile and uncertain period for Meta.
Why Non-Listed Businesses Should Care About Their Potential P/E Ratio
Even though private companies don’t have a public stock price, understanding their potential P/E ratio (Price-to-Earnings ratio) is critical for several reasons:
1. Valuation Benchmarking
A P/E ratio helps compare a business’s valuation to industry peers, including public companies. For example:
- If public competitors trade at 15x earnings, a private firm valued at 20x may need to justify its premium (e.g., faster growth, unique assets).
- Investors use P/E-like metrics to assess private deals. A high ratio signals confidence in future earnings; a low ratio may flag undervaluation.
Often listed companies trade at higher P/E ratios to those of private firms as listed companies generally have easier access to capital. With growing private equity the playing field is leveling.
2. Attracting Investors or Buyers
Private firms often calculate an implied P/E ratio during funding rounds or sales. For instance:
- If a company earns 1M annually and seeks a 15M valuation, its implied P/E is 15x. Investors will ask: “Is this growth rate worth 15x vs. public peers at 10x?”
- A justified P/E ratio builds credibility during negotiations.
3. Strategic Decision-Making
- Reinvestment vs. Payouts: A high P/E ratio (like Berkshire Hathaway’s) suggests investors prefer earnings to be reinvested for growth. A low ratio might mean prioritising dividends or cost-cutting.
- Exit Planning: If a founder aims to sell, aligning the company’s implied P/E with industry standards can maximise sale price.
4. Risk Awareness
A mismatch between P/E ratios and fundamentals (e.g., stagnant earnings but high valuation) can expose risks like:
- Overvaluation, deterring savvy investors.
- Underinvestment in growth, leading to stagnation.
5. Funding and Debt Terms
Lenders and private equity firms analyse P/E-like metrics to set terms. A stable or growing implied P/E ratio can secure better loan rates or equity deals.
Example: A Private SaaS Company Valuation
- Earnings: $2M/year.
- Valuation: $30M (implied P/E = 15x).
- Industry Benchmark: Public SaaS firms average 25x P/E.
Why Care?
- The company’s lower P/E suggests undervaluation or slower growth.
- To justify a higher valuation (e.g., $50M, P/E = 25x), it must prove faster growth or superior margins.
Key Valuation Takeaway
For non-listed businesses, the P/E ratio isn’t just a stock market metric—it’s a strategic tool to:
- Align valuation with performance.
- Communicate value to investors.
- Guide growth, reinvestment, or exit strategies.
What’s Next
Raising debt and equity capital for your business needs a consultant with the necessary skills to navigate the financial markets. Convergent Capital Corp can introduce you to an industry specialist who will provide guidance to:
- Analyse sector-specific risks.
- Optimise dividend or growth strategies.
- Avoid valuation pitfalls.
🔗 Contact us for a confidential discussion.
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