Before you can assess the value of an investment or its risk you must review the accounting records. If this is for the acquisition of a small business that you intend to manage yourself, a deep dive into the composition of the financial statements is the minimum that you would require. This includes determining the nature and source of revenues, the types of expenses incurred, and a determination of what is the sustainable level of revenues and expenses. That is what can a prospective purchase expect in a variety of economic environments. What will happen in boom times? What will occur if the economy dramatically slows down? This is called sensitivity analysis.
Once you have determined what these base line earnings are, that is the expected revenues minus expected expenses, you have to apply what is called a capitalization rate. That is the rate of return that would be appropriate for an investment with that level of risk. For most small business, ie those that are owner managed, a relatively high capitalization rate would be required. This means that the prospective owner will want to get an excess return on the acquisition of this business. The reason is that there are significant risks associated with running a small business – uncertainty of the revenue stream, difficulty in projecting the level of costs, the overall economic environment, and the resources necessary to sustain a small business during a downturn. Large businesses have a larger and more diverse customer base, a greater level of financial wherewithal and a greater market presence which results in their having a more stable level of cash flows over the long term.
Another difference between a public and private investment is the its liquidity. That is, you can dispose of a share of stock in a public company easily and with little cost since it is traded on a public exchange. Private companies are much less liquid, finding a purchaser for a business can be a long and time consuming process. That is another reason people are willing to take far greater risks with a publicly traded company. If things go wrong your are out in a matter of seconds.
But no one is buying an entire public company, and if they are it is unlikely they have any interest in reading this web page. What most people will acquire is a share of stock of the company which is a unit of ownership traded on a public exchange. The valuation of this share will determine the long term viability of the investment and the return the investor can achieve. Shares of solid companies with a history of good earnings and hopefully an increasing dividend should provide returns that will make most conservative investors happy. Some investors are willing to take excessive risks on startups or companies with massive revenue growth but no net income, others may be more interested in a stream of dividends to fund their retirement. These different investor profiles result in very different investment choices.
But i would say that regardless of the type of investment you are looking for the qualitative and quantitative parameters that have to be considered are similar.
a) Nature of the business, does it make sense that this business will exist and prosper well into the future. Microchip companies fit this bill, buggy manufacturers not so much.
b) What is the growth in the market from products of the company in the foreseeable future? Will demand for the product be resilient?
c)How much do you have to pay for this company. What is the price in relation to the level of earnings.
d) What is the financial position of the company? Does it have a solid working capital position? Is it heavily in debt? What is the relationship of debt to earnings?
e) What is the level of interest rates in the broader economy? Obviously at times of very high interest rates, business valuations go down. If you can get a 10% return on government bonds, a similar return on a stock which has a much higher level of risk may make little sense.
So that is it. There are many boxes to fill out prior to making an investment decision. Although i could give my own opinion, ultimately it will be up to the investor to make up his own mind in light of his acceptable level of risk, personal experience and expertise, and his perceptions of the overall market at the time of the purchase. In the end, it is a very personal decision.