I wasn’t planning on writing a follow-up blog about market timing, but given some recent conversations I have had on current markets (as of this writing the TSX is down ~ 2% YTD, the S&P down ~10% YTD and the Nasdaq is down ~17% YTD) and how that performance (or lack thereof) can influence the mood of both sellers and buyers, I thought it worth while. In particular, I wanted to explore the concept of market timing and some of the other dangers that come with trying to “top tick” the sale of your business.
The other day I was speaking with a successful owner in his fifties who runs a specialty repair business generating ten million dollars in revenue and approximately two million dollars in profit before tax. He has successfully navigated the business through COVID and even though he was tired and nearing burnout, he was planning to wait another three to five years before selling his business because he “wanted to sell at the peak of the next economic cycle.”
On the surface, his rationale seems to make sense. In strong markets, like what Western Canada was in 2010-2014, as sentiment and commodity prices strengthened, valuations crept up and a business at that time was probably worth two turns more then, than what that same business would sell for in 2017/2018 (or during the summer of 2020 and when COVID concerns were generally at their peak). For clarity, a “turn” is a multiple of earnings, so that a business selling for five times earnings (or five turns) at the peak of an economic cycle may go for as low as three times earnings (or three turns) at a low point in the cycle. Side note: You have to be a bit careful about what a “turn” really means. Most advisors use it as a turn of EBITDA or sometimes a turn of debt (that in itself is referencing debt to EBITDA), but sometimes tech companies will refer to a “turn of revenue” (because they don’t have any earnings) so when you hear the term, clarify what the user is intending.
The problem is, when you sell your business, you have to do something with the money you receive, which usually means buying into another asset class that is being affected by the same economy. Let’s say, for example, you had a business generating $1,000,000 in pre-tax profit in an industry that trades between three times earnings and five times earnings, depending on the point in the economic cycle (typical for Western Canadian Oil Field Service Companies).
Furthermore, let’s imagine you sat stealthy on the sideline until the economy reached the absolute peak and sold your business for $5,000,000 (five times your pre-tax profit) in October 2007. You took your $5,000,000 and bought into a Dow Jones index fund when it was trading above 14,000. Eighteen months later – after the Dow Jones had dropped to 6,547.05– you’d be left with less than half of your money (a paper loss of $2.5 million…ouch).
Even though you cleverly waited till the economic peak, by March 9, 2009, you would have effectively sold your business for less than 2.5 times earnings. The inverse is also true. Let’s say you waited “too long” and sold the same business in March 2009. And because you were at the lowest possible point in the economic cycle, you only got three times earnings: $3,000,000. Notice that’s 20% more than if you’d sold at the peak and bought an index fund at the top of the market.
Just like when you sell your house in a good real estate market, unless you’re downsizing, you usually buy into an equally frothy market. Which is why timing the sale of your business on external economic cycles is usually a waste of energy.
Instead, we recommend timing the sale of your business when internal economic factors are all pointing in the right direction: employees are happy, revenue and profits are on an upward trend, and there is still lots of market share for an acquirer to capture.
When internal economic factors are pointing up, you’ll fetch a price at the top end of what the market is paying for businesses like yours right now, which means that – for good or bad – you get to use your newfound cash and buy into the same economic market you’re selling out of.
We would love to hear your story – please feel free to contact us anytime (we are good with evenings and weekend chats).