The private company sector
- It can be considered as a unity, representing a range of companies from those being built on modest footings to those which reach a size at which they become attractive targets to listed companies.
- It can also be considered as representing two populations. There are those businesses which are meteoric, with high ambitions and high achievements. On the other hand there are the more personal businesses whose comfortable horizons are those of the town or district in which they operate.
There are some challenges with the second assumption because ambitions generally run ahead of achievements. It will sometimes be difficult to determine into which population the relevant business fits. However, despite these difficulties, it does reflect an underlying truth regarding the aims and intentions of many business owners.
The two populations of companies are likely to have very different growth and other dynamics. They should each always represent constant proportions of GDP. However the growth of the individual smaller, more pedestrian businesses will be held on average, below the rate of growth in GDP.
This is the result in part of business failure and partly as a result of new business formation, which I've described as the churn effect.
Meteoric success stories
We need to examine the growth potential of the population of the more stellar companies. We can approach this from several directions. The first point to make is that, in aggregate, we must assume that they represent a constant proportion of GDP.
The next point to make is that, like their more circumscribed cousins, they must also have their growth constrained by those businesses which fail. However, this is almost certainly more than compensated for by those companies which are truly meteoric, which achieve dizzy rates of growth, and are then found to be attractive to acquirers.
If they are acquired by listed companies they leave the population of privately owned companies at that point. Their very size and their continuing growth then provide a boost to the listed company sector.
Impact on the listed company sector
We can examine this factor indirectly by considering the visible evidence from the listed company sector. There have been various surveys of long term equity returns. Examples are Arnott and Bernstein, and Dimson, Marsh and Staunton. One such survey was undertaken of 16 countries in the period from 1969 to 2009.
As might be expected, the earnings of the listed sector in each of these countries grew broadly in line with GDP. The average was real growth of 2.4% a year. However, the growth in earnings per share was very modest. It appeared that this was largely caused by a dilution equating to 2% a year.
This arises from two factors
- The issue of new shares to management as part of various incentives.
- A large part of that growth being acquired, in the form of purchases of companies outside the listed sector, or the entry of new companies onto the markets.
In many of these markets there was a very significant boost to shareholder returns as a result of a major re-rating in this period. Price earnings ratios had a tendency to increase and dividend yields fell.
Dimson, Marsh and Staunton dissected the equity returns in 19 markets over 111 years to 2010. The average real growth in dividends was 0.46% a year in the UK and it was 1.37% a year in the USA. Both of these figures are less than the real rate of growth of the respective GDPs.
It is possible that some small part of the difference may be accounted for by a different pay-out ratio, but this is unlikely to explain the whole of the shortfall.
It is a point simply made by Arnott and Bernstein that investors may expect to receive GDP growth in their returns, however what they actually receive is the return on those companies in which they have invested. If they remain with their original holdings throughout they will miss out on the performance of the new entrants to the market.
Therefore the meteoric private company sector appears to provide the listed company sector with a significant growth boost. The information seems to suggest that many such high growth companies grow at relatively high average annual rates, probably very much higher than the rate of growth in GDP.
There is then a venting effect as some of the most successful of these companies leave the private company sector and become part of the listed sector. The average growth rate is therefore trimmed back to GDP rates by failures and by these exits.
The different populations of private companies
If the population of private companies is considered as two separate populations, and if the conjecture is accepted that they have startlingly different growth patterns, then there are some interesting conclusions.
We must ask if information relating to the transactions involving the stellar companies, offers much useful guidance as to the pricing of the smaller, less distinguished businesses.
This transaction data is generally more visible than that relating to transactions in smaller companies and it therefore tends to figure large in thoughts of small company valuation.
It is notable that Dohmeyer, Butler and Burkert, in their article in Business Valuation Update, have purposefully excluded transactions in which private companies were sold to listed companies.
They have done this for two reasons
- Such transactions were unduly weighted in the database of private company transactions.
- They consider such companies to be atypical of the great mass of the slower moving private companies. For whatever reason, they had very unusual qualities which made them attractive to public companies.
Many of us will doubtless consider that this approach chimes with our own experience. Most valuation assignments will be of companies with turnover of £10m or less and my experience is that the vast majority of such companies are not going to develop qualities which make them attractive to listed companies.
Summary
The two fundamental components of valuation are growth and risk. If there are material differences in growth between the two sectors of the private company populations, then the prices achieved by those companies which are acquired by listed companies are unlikely to provide much in the way of useful guidance to the values of most smaller private companies.
Andrew Strickland, Corporate Partner, Scrutton Bland
Valuation Group May 2014
