How We Think Like Private Buyers
Thoughts on treating stocks as ownership in operating businesses
Many prominent investors, most notably Buffett, have long preached that stock market investors would be well served by thinking about stocks the same way a private buyer would think about buying an entire business. Adopting this mindset may be our single most important filter when it comes to evaluating stocks and whether or not to buy or sell them. We simply ask ourselves, if we had unlimited capital and the opportunity to acquire 100% of this business personally, is it of a quality and selling for a price that we would happily do so? If the answer is no, we pass, and if the answer is yes, we keep going.
While it’s great to say you think about stocks like a private acquirer would, what does that actually mean in practice?
Before going into how we apply this mindset, I’ll also modify the advice from “think like a private buyer would think” to a slightly more clunky but more accurate “think like a permanent buyer operating with their own money would think”.
Having spent time in private equity and continuing to occasionally participate in the private market, it’s clear that buying a business privately with other people’s money often entails an entirely different set of criteria than when investors are putting their own capital at risk when buying a private business. This is not surprising, but it is important to remember.
Thinking like a private buyer might mean something different to different people, the key is finding out with it means to you. Given your circle of competence, target returns, risk tolerance, and skillset, what would you look for if you were going to buy an entire business? Here are some thoughts I recently offered a friend that was advising a client who was evaluating the acquisition of a small business as a first time buyer. Each of these criteria applies equally to the public markets and helps us be better long-term investors regardless of asset class.
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Private Acquisition Checklist
Is the business predictable?
As a private, permanent owner, you’re going to very much care about what the business will look like in five years and in ten years. It’s hard to get a handle on the long-run economics of any business, let alone one that is in a rapidly changing industry, a projected-based industry or has otherwise very little line of sight into future revenue prospects.
Note that demanding a certain level of long-run predictability does not necessarily mean buying a business with no cyclicality at all. While we greatly prefer non-cyclical businesses, we’ll still study and occasionally invest in cyclical companies as long as we can get a handle on the cycles and make normalizing adjustments to any one given year.
Predictability to us means being able to nail down the long-term demand drivers for price, volume, customer ordering patterns and behavior, and competitor dynamics. The result is that we largely invest in highly predictable business models such as royalty, subscription, non-discretionary, or high back-log businesses. We’re able to understand the long-term earnings power much easier and can subsequently value the company and its forward return prospects with more confidence.
For example, this means in a private transaction it’s a lot easier to value a subscription-based car wash than it is a tool and die machining job-shop.
Is the business high quality?
If a private buyer is going to lock up their capital for many years it should be in a business that earns a good return on that capital. There are many ways to define what constitutes a “good business” but we like to use some form of return on capital measure.
When evaluating if a business is high quality I like to start with return on tangible capital. This gets me closest to understanding the economics for a private owner who started the business. Normally, a measure of EBIT divided by capital employed (or net working capital plus net fixed assets) paints an initial picture of the economics of a business. All else equal, a private buyer would much prefer to own a company that generates $500K of operating income for every $1M of tangible capital they invest in the business compared to a lower quality business that only generates $100K of income for every $1M of capital invested.
Looking at pre-tax and pre-interest earnings normalizes for differences in capital structure between businesses and helps compare opportunities on an apples-to-apples basis. To be sure, interest and taxes are very real and important expenses, which is why we do not use EBIT or EBITDA to value a business, we just use EBIT as one initial gauge of assessing business quality. More on that below.
If a business passes the good business filter by way of earning high returns on capital our next question is to ask how likely is it that those high returns endure? We need to be able to identify to qualitative factors – switching costs, barriers to entry, branding, scale, or some other competitive dynamic – that we can point to to give us confidence that those attractive returns are sustainable. A private buyer would not be interested in locking up their capital in a business that had one good year but is bound to have those high returns competed away in short order. The public market is no different.
It is often harder to assess durability in private markets as buyers often have a much more limited information set and fewer years of historical financials to work with. On the flip side sometimes it’s easier because you have direct access to the owners and operators of the business to help you understand the competitive landscape more directly.
What is the industry structure and competitive landscape?
Grasping the industry structure that a business operates within is closely linked to the predictability and the quality of a business. We prefer to fish in stocked ponds, meaning we like to stay away from tough industries. Oligopolies (either global or local) or otherwise rationally competitive industries are much preferable to brutally competitive industries.
The easiest indicator of industry rationality is pricing dynamics. Buffett has gone so far as to say this is the most important question to ask when evaluating a business either publicly or privately:
"The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by 10%, then you've got a terrible business."
Businesses that can easily pass along price increases, at least at the rate of inflation, and have stable to growing margins, are usually operating in rational industries.
Private owners need to also understand how their business competes and wins customers. If all customers in the industry care about is price, the business is likely low-quality and commoditized. If there are other important factors in winning business, such as convenience, speed, lack of competitors, or anything else, it may be an indication of a good competitive landscape.
Valuation and Forward Returns
Forward returns and valuation are tied at the hip. This is especially true for private buyers and for our approach to valuing and underwriting prospective returns in the public market.
As our long-time readers know, we underwrite our investments with a free cash flow yield plus growth framework. This is absolutely how a private buyer should think. A permanent owner’s return will mirror the cash that they can distribute to themselves each year in relation to their purchase price plus any growth.
Thinking like a permanent private buyer takes valuation multiple expansion largely out of the equation and forces you to think about the business return you’ll earn. The business return is a direct result of price paid, so it still forces you to be highly valuation conscious.
The value a private buyer would be willing to pay for an entire business is a function of their expectation of distributable cash flow and their targeted rate of return.
Let’s say I buy a small landscaping and snowplow business and I am very confident it will consistently generate after-tax and after-debt service distributable cash flow of $750K and my targeted return is 15% per year. I would value that business at around $5M, or $750K divided by 15%. In other words it will return 15% of my purchase price in cash dividends to me, the owner, each year.
If I can get the business for less, that would be great and represent a margin of safety in case my earnings projections were wrong. If that business then grows at a GDP rate of around 3% my returns will be around 18% per year, which would be an excellent outcome if sustained for a long period of time.
Maybe another buyer is only looking to generate a stable, non-correlated return of 10% and they find a business that is almost guaranteed to kick off $250K in distributable cash flow each year. They would probably pay around $2.5M for that business.
In a private transaction, the valuation a private buyer would pay is nothing more than a function of the cash flow and their targeted return; to us, analyzing a stock is no different. We are simply trying to understand, using conservative but realistic assumptions, how much cash will be available for shareholders and then pay a valuation that will allow us to earn an acceptable return without relying on a valuation multiple re-rating. Just as a private buyer would do when purchasing a business for keeps.
We still expect valuation re-rating as a cherry on top, but we don’t rely on it for the bulk of our returns.
Capital Structure
The last step in buying a private business comes down to how you structure the transaction. How much equity should you use vs. traditional bank financing vs. junior debt vs. seller financing vs. a seller rollover or an earnout? The possibilities are almost endless when thinking about the right cap structure.
Fortunately, public markets are a little simpler as we just need to understand how much leverage a business has the capacity for compared to how much leverage they currently have on the balance sheet. We’re not afraid of leverage as long as it’s appropriate. There is no hard and fast rule as to how much leverage we are comfortable with as it depends on the business model. I will say that the right amount of leverage is decidedly not “as much as you can get” which is often what ends up happening in public and private markets. This is often a receipt for disaster and a change in ownership.
What a private buyer should NOT care about
Unfortunately, most private buyers, particularly in private equity, often do not look at businesses the way I’ve described above because a) they are using other people’s money to buy businesses and b) they are not permanent owners but rather looking to flip the business in a few years. To be clear, there are many reputable private equity firms that are outstanding investors and do add value, but the vast majority do not. This is no different than in the public markets.
In most private transactions, valuations are based off of silly metrics such as EV/EBITDA multiples. Instead of basing the valuation off of a FCF yield plus growth, valuations are based off of comparable transactions or seemingly pulled out of thin air. To make matters worse EBITDA – already a flawed metric – is heavily adjusted and generally does not represent anything close to distributable cash flow.
This often turns into a game of hot potato where buyers hope to use as much leverage as lenders will allow, pay off a little debt over a few years, hope EBITDA improves a little, and sell at a slightly higher valuation multiple than they bought. Sound familiar? If so, it’s a lot like the public markets. I can assure you this is not how successful long-term private owners behave.
Additionally, private owners do not optimize for quarterly results or even GAAP profits, they optimize for long-term distributable cash flow. Likewise, in the public markets if we can find a situation where GAAP or short-term financials do not reflect the long-term free cash flow of a business, it often leads to a great investment opportunity.
Perhaps most importantly, private owners are not on the edge of their seats waiting for the next jobs report, Fed press conference, or dissecting the latest spat between Elon Musk and President Trump. They’ve following their business fundamentals, and that’s what long-term stock market investors should do too.
Just attempting to think about buying a stock as if you were going to buy the entire business privately will force you to think like a business owner and give you a major advantage over most public markets participants. It means you’re playing a different game.
You’ll be less likely to allow the price of a stock to drive the narrative and more likely to think from first principles. It will help elevate your thinking away from worrying about quarterly noise and sensationalized headlines towards thinking about the long-tern business fundamentals. It’s not only more fun and enjoyable, we’ve also found it’s a lot easier way to earn durable returns, at least for us.
Further, the nice thing about public markets is even if you look at a stock as a private owner, you don’t literally have to be a permanent owner. It just helps to think like and be willing to be a permanent owner. When you’re wrong in the public markets you can always sell, the same is not true in private markets. Stock investors can have the best of both worlds; thinking like a private owner when others do not and also taking advantage of the liquidity of the stock market.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.