In the private business world, vendors often list businesses for sale as price plus stock. For example, you may see a business advertisement with the price listed as $Xm + SAV (stock at value). The vendor is assuming a separate value for the business (assets, goodwill, etc.) and a separate value for the stock (or inventory).

If this business is an insurance company and the stock refers to a few cows at home, then I can understand the separation. But, if the business is a computer retailer and the stock relates to computers for sale, then I disagree with the separation. (The business requires the stock to operate.) The price for any business should relate to the cash flows of the business. Without the stock, there is no business and there aren’t any cash flows. Ergo, the stock and the business are one, and the total price paid should reflect the value of the cash flows from the combination.

Let’s try an example. Say a vendor asks for 4x earnings plus stock. Earnings are $10m and stock is worth $30m. So that equals $40m + $30m, which equals $70m. To me, that’s 7x earnings, not 4x. The usual argument from the vendor is that if I ignore the value of stock and only pay $40m, then I could run the business for a year ($10m in earnings), sell all of the stock ($30m+) and I’d have all of my money back, hence, I am only paying 1x earnings. At first, that seems reasonable.

But, my assumption is that the business needs $30m in stock to operate properly (as a result of lead times, bad stock, warranty claims and forward orders). So, if I sold the $30m in stock, then I couldn’t operate the business properly and hence wouldn’t have a business with ongoing earnings of $10m anymore. What this inventory requirement really represents is a necessary investment in the business to maintain normal operations. It is an investment to produce the $10m earnings; it will not lead to extraneous earnings. Moreover, if there are plans to grow the business, the inventory requirement will increase and the business will require additional investment.

When I say I’ll pay 4x earnings for the ongoing cash flows of $10m, that $40m includes my total investment to produce those cash flows; it includes the initial purchase price, the adoption of any debt, working capital requirements (including inventory) and anything else that is deemed a liability (such as pension provisions). If, for example, pension provisions plus required inventory totals 4x earnings and I only want to pay 4x earnings, then it becomes investment gratis (purchase price zero).  (Sometimes a business is worth more liquidated than as a going concern.)