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A Compelling Reason to Sell Your Business in 2015

Price to 10-Year Average Earnings (PE/10)
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Why should 2015 be the year?  Because valuations are nearing record highs (and trees don’t grow to the sky).

Note that I am not referring to the stock market per se, although the S&P 500 and Dow Jones Industrial Average have both reached record highs in 2014.   I’m referring to the price-to-earnings ratio (or “PE”) as well as the “PE/10” a measure of the ratio between current stock prices and the 10-year average earnings of the S&P composite, which Nobel laureate economist Robert Shiller refers to as the Cyclically Adjusted Price to Earnings (CAPE).

Price-to-Earnings Ratio of the S&P Composite from 1871 to 2014

Price-to-Earnings Ratio of the S&P Composite from 1871 to 2014,           Source: Advisor Perspectives, Inc.

 

These “capital market” indicators correlate closely with M&A activity, as a rising tide lifts all boats.   High stock prices for publicly traded companies provide them with low-cost access to capital and make acquisitions more attractive.  More buyers in the market then drive up the price for closely-held businesses.

2014 looks to be the best year for M&A since the downturn in 2008, and as a result, valuations for private companies have been on the rise.   Larger private companies with EBITDA of $10 million and up are seeing valuations of 8x to 10x earnings.   Businesses with $5-10 million of EBITDA are getting valuations of 6x to 8x earnings in the current market.

 

How high is too high?

The mean PE ratio for the S&P composite since 1871 has been 15 times earnings.   Currently, the ratio is 18.9 times trailing twelve months earnings, and approaching the 20x multiple that always seems to precede a major market correction.  In the roaring 20’s, the market reached a PE ratio of 25.2, and remained in the 20x range until Black Tuesday in October 1929, when the great crash signaled the start of the Great Depression.

In the Dot Com bubble, the nominal PE reached 34x, and it was briefly 46.7x during the housing bubble.   By comparison, 18.9 doesn’t seem so high at all.

 

The PE/10 tells a different story.

The chart below illustrate the PE/10 ratio over time.  Therefore, instead of dividing the current stock value of the S&P 500 by their earnings for the most recent year, it divides by average earnings over the past 10 years.    The mean PE/10 ratio is 16.5 times the 10-year average earnings.  The current PE/10 is 27.03, which is slightly higher than the same ratio at the peak of the housing bubble, and has only been higher twice in history – immediately before the 1929 stock market crash (32.6x), and just above 44x before the dot com bubble burst.

Price to 10-Year Average Earnings (PE/10)

This second chart shows not only the PE/10 ratio over time, but also highlights (in gray) the periods of recession.

After dropping to 13.3 in March 2009, the PE/10 ratio has rebounded to an interim high of 23.5 in February of 2011 and then hovered in the 20-to-21 range. The latest ratio is at a new interim high — the highest since December 2007.

As Doug Short points out in his article “Is the Stock Market Cheap” earlier this month, “The price rebound since the 2009 low pushed the ratio back into [record high territory]. By this historic measure, the market is expensive.”  In fact, at 27.03 today, the ratio is 73.5% above the mean, compared to 56% above the mean in November.

Should I stay or should I go?

As I noted at the top, trees don’t grow to the sky.   As such, the market doesn’t have a lot of room for improvement at this point.  Certainly, corporate earnings will grow as the economy expands, and if the rate of earnings growth outstrips stock market prices, the PE/10 will begin its regression to the mean without a major correction.  But if history is any guide, the stock market tends to run up fast and inevitably correct in the form of a stock market crash.   It’s really only a question of when.

The implication for someone interested in selling a business in the next 5 years is simple.   If you wait too long, you may find yourself ready at a time when the market has already corrected and valuations are considerably lower than they are today.