In the best of times, my crystal ball is hazy. Even though I have been a business owner for over two decades, I find it hard to make good economic business decisions by predicting the future. However, I am not sure that I have ever seen things hazier than they are right now.
I am always looking for new businesses to acquire that we can integrate into our existing business. I get business listing notifications by email constantly, and I can tell you that these are strange times. We all know about the red-hot housing market, but the same seller’s market exists in business. Severely high-priced businesses hit the market one day, get multiple offers, and sell the next day.
Traditionally, businesses are priced based on their net worth (assets – liabilities) + their income potential. So for example, if a business has $1 million in intellectual property assets and $1 million in inventory, it would sell for $2 million + some kind of multiple of income.
A common traditional multiple of income in the kind of businesses we target is 2-3X. In other words, in our example, if the company has a net income of $500K/year, we might expect to pay between $3-$3.5 million for the business. This consists of $2 million for the assets plus another $1-$1.5 million based on the income multiple.
Today, sellers are asking for and getting higher income multiples. In many cases, the multiples are obscene. You can see this just by watching Shark Tank. When you see a company with no real assets and $500,000 in sales pitching a $10 million valuation, you are perfectly right to scream at your TV screen. While Shark Tank is a typical reality TV show (meaning it is not exactly reality), I think it is a pretty good indicator of what is happening to business valuations. These days, the pitches there are just nuts.
The last time I saw this phenomenon was about a dozen years ago. We all know what happened back then both in real estate and the stock market.
I suspect strongly that we are going to see it happen again.
These days, I sift through the business listings that pop up and reject almost every one of them right away. To me, they fall into three categories: too risky, outright junk, or overpriced. At the moment, I am perfectly happy on the sideline. Buying businesses at these prices in this environment is not for me. That is true even though I am looking for businesses that we can easily integrate into our existing systems and greatly improve right out of the gate.
That being said, I am the first to admit I may be wrong about all this, and in my hesitancy to take on this kind of risk, I might be actually taking on more risk. It all comes back to what you believe about inflation.
Most of us already see inflation everywhere we look. There are a few reasons why. First, the government is pumping tons of money into the economy which devalues the money already in the economy. That is one reason why prices are going up and wages are going up. I can tell you that the wages we need to pay to hire quality employees have jumped 30% in the last year. It costs more to run a business today than a year ago and that is driving up prices.
I tend to not believe that the government pumping is that big a deal long term. Even when you start tossing trillions of dollars at the economy, that is still just a fraction of the overall GDP. The average person will take the $1400 stimulus and buy another 65″ TV they don’t need, and that will be the end of it. The unemployment benefits are a bigger deal, but that will eventually end as well.
To me, a bigger problem is that commodity prices are going up rapidly. For example, a big driver behind the real estate run-up is lumber, which has jumped enormously during the last year. Steel is up, food is up, and fuel is up. Everything coming into our warehouse from cardboard to finished products is costing more, and in some cases, a lot more.
The big question is whether this inflation is temporary and covid-related. My gut and experience tell me that that it is indeed temporary, and that is driving my decision-making these days. I think that the biggest reason we are seeing enormous inflation in commodities is simply because of shipping logistic problems caused by covid. I know about this problem because my business is dealing with it every day.
If you order online, you have probably noticed how inconsistent shipping has become. Imagine those problems multiplied across the entire supply chain. Getting anything imported into the United States has become a huge challenge; so has transporting it across the United States. Most businesses I know are facing problems just getting inventory into their warehouse to sell. In our business, this is easily our biggest challenge right now.
While this is a big problem today, I believe it is short-term. I have to think that the market will adjust and shipping logistics will adjust to the new normal. More ships will be built, more containers manufactured, and ports will be expanded. When that happens, commodities like lumber are going to drop almost back to where they were before covid.
In other words, I do not see today’s buying opportunities as some kind of bargain where we are just starting a long period of inflation. I actually think we are on top of a bubble. I don’t see the commodities problem fixing itself within a few months, but I am betting it will fix itself within a year or two.
We shall see if I am right. If I am, I am going to be in good shape when things crash. I will be able to buy businesses at bargain prices. The same goes for real estate.
But if I am wrong? I am going to be doing a lot of hand smacking in five years as I mutter “I should have bought every business I could afford back in 2021.”
Now, many of you do disagree with me on what is going to happen with inflation. That is perfectly understandable. If you believe that inflation is a serious long-term concern, you want to invest your money in assets such as real estate and businesses that will appreciate along with the inflation. Keeping cash actually becomes very risky and downright dangerous because your cash will lose value as inflation occurs.
I have many friends who own businesses similar to mine. We talk regularly about inflation and the possibility of hyper-inflation. And I will tell you that many of them that are normally very conservative with money are furiously trying to reduce cash by investing in real estate and their businesses.
In many cases, they are even borrowing money to buy assets. Even the ones that are normally anti-debt seem to be going in that direction. Remember that just as cash loses value during inflation, the cost of debt does as well. If you can buy an asset with debt for $1 million and inflation takes the value of that asset to $2 million within a few years, borrowing the $1 million looks pretty smart.
I get why they are borrowing money, but that is not a train I am going to board. In fact, the fact that my most debt-adverse peers are suddenly borrowing money makes me more confident that I am right and we are about to see a big correction. Personally, I am still of the mindset that the best place to be is sitting on cash with no debt.
If you disagree with me about inflation, I can understand why you might want to buy a business. If you do buy though, just keep in mind that you are not buying at a bargain if you are considering historical pricing methodology.
Also, keep in mind that it is hard to look at the current situation and not see a lot of risk. Don’t get me wrong: business always involves risk, and far more than the average person suspects. But today’s risks are unprecedented in many ways and one is certainly not seeing that risk reflected in the prices for which businesses are selling.
That in a nutshell is what I would tell you about buying a business in 2021. In short, I probably would pass unless the deal is fantastic. But remember this: even if I am right, my timing could be wrong. The bubble I expect to burst may not burst for another five years.
Everything I have just said about buying businesses applies to buying houses as well. I just don’t think this is a great time to be needing to buy a house. If you can afford to wait and you agree with my assessment that the market will self-correct its supply problems, I think you should consider waiting. If you have to buy a house right now, that is an entirely different matter of course. It is not the end of the world either way, especially when looking at the long term.