Often, it is assumed that the "investment" should equal the amount of capital paid in by the owner/investor. When businesses are first starting, this can be appropriate, but quickly this number loses its meaning. After all, one is not just risking the paid-in capital if it has materially appreciated. A good way to think of this is to contemplate receiving property willed to you, which was purchased for pennies in the early 1800s, but now is worth several million dollars. Which would be most relevant when thinking of your investment portfolio, the purchase price or its current value? Put another way, you buy the shares you own every day at the market price you forgo. This "marking to market" concept is critical to quantifying the true "investment."
As mentioned earlier, the security alarm industry routinely uses a multiple of RMR to express the value of companies and/or accounts that have traded. While values have fluctuated over time, the market has generally traded most consistently in the 30s as a multiple of RMR. While it is possible a given company could, or should be valued higher or lower, the use of this valuation range should be the place to start when seeking a conservative multiple applicable over time.
In order to complete the approach, an adjustment needs to be made for three assets typically addressed outside of the multiple ("Other Assets"): 1.) cash or cash equivalents; 2.) accounts receivable; and 3.) inventory. From this total asset value calculation, all liabilities are then deducted in order to quantify the value of the equity shares. Written in the same formulaic fashion:
INVESTMENT = (RMR x Multiple) +
Other Assets - Liabilities
Using the approach outlined, here is an example company illustrated over the last three years, with the valuation multiple equaling the 35x mid-point in the range indicated in the accompanying chart. As shown, this company increased the value of its equity from $1.6 million at the end of 2007 to $2.1 million by the end of 2010, with its owner operator contributing an additional $50,000 in capital in 2009.
Are the returns high enough?
This is a tough question. By comparison and depending upon the timeframe considered, long-term average annual returns for investing in the stock market are roughly seven to 12 percent. Investment theory would suggest this owner operator should receive a premium over these returns for investing in such a small company, where there is no liquid market for the shares.
On the other hand, this investor knows the business intimately and has complete control over the decisions made by the enterprise. Additionally, the stability of the industry and this company's performance is impressive, as is the relatively constant market for the selling of companies of this size.
While many companies we have reviewed generate returns higher or lower than those reflected above, this range is what we tend to see most often. Additionally, the vast majority of these investors are staying the course, which suggests that there is at least some consensus that these return levels offer adequate compensation for the risk.
Using tools such as those outlined above allow owners to gain a view on how their investment is doing and also potentially point to ways in which they can improve their returns.
Michael Barnes is a founding partner of Barnes Associates Inc., a consulting/advisory firm specializing in the alarm industry.