Private Company Valuation: Everything You Need To Know
Posted by Valentiam Group on May 26, 2020
Private company valuation poses some specific challenges not encountered in the valuation of publicly-traded companies. Because private companies aren’t publicly traded, they are not required to publicly disclose their financials—and obviously, there are no stock metrics available for comparison to other similar companies. In addition, accounting standards for private companies are often less stringent, so their financial statements may be less standardized and lack the clarity of a public company’s metrics. In family owned and operated businesses, it’s not uncommon for there to be some intermingling of business and personal funds which needs to be resolved before performing the valuation. All of these factors equate to less transparency in the financials of private companies, and make private company valuation more challenging than determining value for a publicly-traded company.
So, how do you determine the value of a private company? Although there are some unique challenges involved, the fundamental approach to valuation is the same. As we explained in a previous article, there are three basic approaches to valuation, and these apply whether the subject company is public or private:
- Market approach
- Income approach
- Cost approach
These three approaches align with the Certified Financial Analyst (CFA) valuation designations of multiplier (market approach), present value (income approach), and asset-based (cost approach) valuation. In this article, we’ll examine how you value a private company using each of the three valuation approaches, even without the data you would rely on for valuing a public company.
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Private Company Valuation Methods
Although information is generally harder to come by for private companies, it is still possible to calculate values by using the information that is available for both the subject business and similar companies—both private and public.
Market Or Multiplier Approach
Because it is difficult to establish private company valuation multiples, the most common approach is to use comparable company analysis (CCA). (Tweet this!) In this approach, the appraiser searches for publicly-traded companies that closely resemble the subject company.
Using this approach, public companies in the same industry of a similar size, age, and growth rate are identified, and averages of their multiples or valuations are calculated for comparison to the subject company. This gives the appraiser an idea of where the subject private company fits within the industry and how it compares to its competitors.
After compiling the price-to-earnings, price-to-sales, price-to-book, and price-to-free cash flow metrics for comparable companies, the EBITDA multiple can be used to help calculate the subject company’s enterprise value. This is calculated by dividing the enterprise value by the subject company’s earnings before interest, taxes, depreciation, and amortization (EBITDA).
If there are recent acquisitions, mergers, or initial public offerings (IPOs) of stocks for comparable companies in the industry, the information from those transactions can also be used to help estimate the subject company’s value.
The obvious drawback to CCA is that no two firms are exactly the same, so at best these comparisons will provide only an estimate of the subject company’s value. However, these comparisons are useful for determining how the subject company “stacks up” to others in the industry in terms of financial performance.
Income Or Present Value Approach
The basis of the income or present value approach is the premise that the subject company’s current full cash value is equal to the present value of future cash flows it will provide over its remaining economic life.
Estimating the revenue growth of the subject company by averaging the revenue growth rates of the comparable companies and then adjusting for company specific factors is the first step. After estimating revenue growth, expected changes in operating expenses, taxes, and working capital are estimated. Once all of these estimates are completed, free cash flow is calculated, providing the operating cash remaining after the deduction of expenditures. The next step is calculating the average beta (measure of market risk, disregarding debt), tax rates, and debt-to-equity (D/E) ratios of comparable companies, and ultimately, the weighted average cost of capital (WACC).
Calculating The WACC
The cost of capital is the minimum required rate of return market participants demand before they consider making an investment. The cost of capital for a particular investment is the opportunity cost of foregoing the next best alternative investment; this is based on the logic that an investor will not invest in a particular asset if there is a more attractive investment.
In the development of cost of capital, a typical, market-derived capital structure must be established. This capital structure must consider the blend of debt and equity, which the typical buyer would use in purchasing the operating property of a similar company or group of assets. All costs connected with each type of financing within the capital structure must be calculated. Two components make up the costs of financing: the yield for debt and equity, and the cost associated with the issuance of those associated securities.
When applying the income approach, the cash flow expected by the subject company over its life is discounted to its present value equivalent using a rate of return reflecting the relative risk of the asset and taxes, as well as the time value of money. This return, known as the weighted average cost of capital (WACC), is calculated by weighting the required returns on interest-bearing debt and equity capital in proportion to their estimated percentages in the subject company’s expected capital structure.
The general formula for calculating the WACC is:
WACC = (Kd × D%) + (Ke × E%)
For a private company valuation, the cost of debt can be determined by examining the subject company’s credit history and the interest rates being charged to the company. Equity can be estimated using the capital asset pricing model (CAPM). The debt and equity ratings and the cost of capital for comparable companies are also factored into WACC calculations.
After the WACC is calculated and taken into account, we can estimate the value of the subject company in comparison to similar companies.
The main limitation of the income approach in private company valuation is that the calculated value is very sensitive to assumptions about the forecast period, the cost of capital, and the terminal growth rate. Any small changes in these key assumptions will have a material impact on the derived value—and that impact may be substantial. Projections are tricky; assumptions about conditions even several years in the future may or may not hold true. Accordingly, income-based valuations are the most reliable for established businesses with predictable, stable cash flows.
Cost Or Asset-Based Approach
Using the cost approach, we can “re-create” the private subject company from the ground up to estimate its value, calculating the cost to replace the existing assets. The cost approach is based on the principle of substitution—prudent investors will not pay more for an asset than they would pay for a substitute asset of equivalent utility. Once we have assigned replacement costs for all assets, that cost is then adjusted by depreciation to arrive at the current replacement value less depreciation of the subject company.
An advantage to this approach is that it does not rely on comparables, which are likely to differ from the subject company in sometimes substantial ways. It is a very solid valuation method supported by current market costs and conditions. The limitation is that this approach requires a lot of reliable data and calculations; developing this information is very time-consuming.
Any of the three methods can be used to estimate private equity valuation, the cost of equity for a private company, or the valuation of private company shares. The values derived from each approach might be close; in situations involving intangible assets, the best way to value a private company might be to average the values derived from each of the three valuation methods. Whether one approach or an average derived from multiple approaches is used to determine value, there is one additional factor that should be considered when valuing a private company: value discounts.
Regardless of the method used for estimating the subject private company’s valuation, several discounts need to be taken into consideration and applied where appropriate:
- Marketability discount: This discount considers the lack of ability to rapidly convert an ownership stake to cash.
- Key man discount: This discount might not always apply; it depends on the nature of the business. If the business is in a stable industry and already well-developed, losing a key employee or leader might not have any impact. But if the company is young or there is a lot of value associated with a particular individual, the impact of that person leaving could be substantial. Apple provides the best example: After Steve Jobs was forced out of the company, Apple experienced several disastrous years, only recovering after Jobs was brought back onboard. The value of Apple without Steve Jobs was substantially less than it was when he was leading the company.
- Control discount: If a minority stake in a private company is sold, a value adjustment needs to be made to account for this lack of operational and financial control. This can also apply in a public company but will have a much smaller impact; the impact in private companies is much more significant due to the lower level of transparency associated with private businesses.
Although private company valuation presents some challenges not associated with the valuation of publicly-traded companies, the methods for calculating value remain the same. (Tweet this!) While the information needed to estimate value may be more difficult to obtain and require some additional calculations in the selected valuation approach, the principles for establishing value that undergird each approach operate the same way when valuing private businesses as they do when valuing public companies. Due to the reduced transparency of private company financials, however, it may be advisable to use more than one approach to ensure that your estimate of value is accurate and defensible.
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Topics: Business valuation
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