If you follow financial news, you probably notice how much attention price-to-earnings ratios receive. For the uninitiated, price-to-earnings is a company’s share price divided by its earnings (profit) per share. As of November 10, 2018, the average P/E ratio for the S&P 500 is just under 16. This means that the share price of an average company in the index is worth about 16 times that company’s annual profit. Consider, then, the oft-touted FANG stocks (Facebook, Amazon, Netflix, and Google). These firms enjoy P/E ratios of 22, 96, 108, and 42, respectively. Similarly,  biotech and pharmaceutical companies Amgen, GlaxoSmithKline, and Merck have P/E ratios of 52, 42, and 60. Both categories enjoy multiples far above the market average. Contrast those with consumer goods companies such as Kroger, Macy’s, or Ford, with P/E ratios of 7, 7, and 6 — far below the market average.

As an angel investor, the public markets often seem like a far-fetched fancy, given the rarity of IPOs. However, because data on the seed stage ventures where we place our investments remains largely opaque, public company valuations provide useful comparable data when we evaluate a given company. Inferring from the multiples above, we learn investors in a tech or pharma company can anticipate far greater value per unit of earnings ($22-108 of value per $1 of profit) compared to investors in consumer goods companies ($6-7 of value per $1 of profit). Fundamentally, this means a consumer goods startup will have to work harder than a tech or pharma company to achieve the same terminal valuation at liquidity. If a tech startup earns profits of $5 million, it might be valued at $500 million. If a consumer goods startup earns profits of $5 million, it might be valued at $35 million. Said another way, the consumer goods startup would need 14 times the profits of the tech company to achieve the same valuation. Thus, tech and biotech startups are often acquired for hundreds of millions of dollars, where consumer goods startups tend to sell for only tens of millions of dollars.

All that is not to say consumer goods companies represent a poor investment, or tech and biotech are good investments. For example, the recently infamous Theranos proves that not all biotech is worth the sticker price. Rather, this split emphasizes the importance of understanding how companies are valued, so we can make more informed investment decisions. It may be true that consumer goods companies tend to garner lower valuations — but that also means we can buy larger stakes for the same size of investment. All else equal, we would rather buy 20% of a company that will sell for $35 million (20% x $35 = $7) than 1% of a company that will sell for $500 million (1% x $500 = $5). Angel investing is all about risk and reward, and although a larger stake increases risk, it also increases the counterbalancing reward.

Nathan Foos is an MBA/JD candidate at Willamette University, and is an alumnus of the WU College of Liberal Arts where he studied history, mathematics, and economics. With a strong interest in the provision of capital to growing firms, Nathan has actively engaged in the experiential course offerings at AGSM, including the O’Neill Student Investment Fund and the Willamette Angel Fund. In particular, Nathan enjoys angel investing because he can engage on a personal level with investee companies, obtain real-world insight into a plethora of industries, and learn from the mistakes and successes of hundreds of startups.