Private company valuation presents certain unique issues not found in publicly listed firm valuation. Private companies aren’t obligated to publicly report their financials because they aren’t publicly traded, and there are no stock measures to compare to other similar companies. Furthermore, because private companies’ accounting rules are frequently less severe, their financial statements may be less standardized and lack the clarity of public companies’ measures. It’s not uncommon for family-owned and operated firms to have some intermingling of business and personal funds, which must be settled prior to the appraisal. All of these issues result in less transparency in private company financials, making private company valuation more difficult than publicly traded firm valuation.
So, how can you figure out how much a private business is worth? Despite the fact that there are some specific problems, the basic approach to valuing is the same. There are three main techniques to valuation, which apply whether the subject firm is public or private, as we outlined in a previous article:
- Market approach
- Income approach
- Cost approach
These three methodologies correspond to the valuation designations of multiplier (market approach), present value (income approach), and asset-based (cost approach) by the Certified Financial Analyst (CFA). We’ll look at how to value a private company using each of the three valuation approaches, even if you don’t have the data you’d need to value a public company.
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Private Company Valuation Methods
Although information for private companies is often more difficult to get by, values can still be calculated utilizing the information that is available for both the subject business and similar private and public companies.
Market Or Multiplier Approach
Because establishing private company value multiples is challenging, the most typical method is to employ comparable company analysis (CCA). The appraiser uses this method to look for publicly traded companies that are similar to the subject company.
Using this method, public firms in the same industry with similar size, age, and growth rate are selected, and average multiples or valuations for comparison to the subject company are calculated. This informs the appraiser about the subject private company’s place in the industry and how it compares to its competitors.
The EBITDA multiple can be used to help assess the subject company’s enterprise value after gathering the price-to-earnings, price-to-sales, price-to-book, and price-to-free cash flow indicators for comparable companies. This is computed by multiplying the enterprise value by the earnings before interest, taxes, depreciation, and amortization of the subject company (EBITDA).
If comparable firms in the industry have recently completed acquisitions, mergers, or initial public offerings (IPOs), the information from those transactions can be utilized to help evaluate the subject company’s value.
The obvious disadvantage of CCA is that no two companies are precisely alike, therefore these comparisons can only provide an estimate of the subject company’s value at best. These comparisons, on the other hand, are valuable for establishing how the subject firm “stacks up” in terms of financial performance to others in the industry.
Income Or Present Value Approach
The income or present value approach is based on the assumption that the subject company’s current full cash value is equal to the present value of future cash flows it will generate for the remainder of its economic life.
The first stage is to estimate the subject company’s revenue growth by averaging the revenue growth rates of comparable companies and then correcting for company-specific factors. Following the revenue growth estimate, the predicted changes in operational expenses, taxes, and working capital are calculated. After all of these calculations are performed, free cash flow is determined, which shows how much money is left over after expenses are deducted. The weighted average cost of capital is calculated after computing the average beta (a measure of market risk that excludes debt), tax rates, and debt-to-equity (D/E) ratios of comparable corporations (WACC).
Calculating The WACC
The cost of capital is the minimal rate of return that market players require before making an investment. The opportunity cost of forsaking the next best alternative investment is the cost of capital for a given investment; this is based on the concept that an investor will not invest in a certain asset if there is a more appealing investment.
A conventional, market-derived capital structure must be constructed in order to develop cost of capital. This capital structure must take into account the mix of debt and equity that a typical buyer would use to buy the running property of a similar company or collection of assets. Within the capital structure, the costs associated with each type of financing must be calculated. The expenses of financing are made up of two parts: the yield on debt and equity, and the cost of issuing the securities that go with them.
The cash flow projected by the subject company over its life is discounted to its present value equivalent using a rate of return that takes into account the asset’s relative risk, taxes, and the time value of money when utilizing the income technique. The weighted average cost of capital (WACC) is computed by dividing the needed returns on interest-bearing debt and equity capital by their projected values, The required returns on interest-bearing debt and equity capital are weighted in proportion to their predicted percentages in the subject company’s planned capital structure to arrive at this figure.
The general formula for calculating the WACC is:
WACC = (Kd × D%) + (Ke × E%)
The cost of debt can be established for a private company valuation by looking at the subject firm’s credit history and the interest rates being paid to the company. The capital asset pricing model can be used to calculate equity (CAPM). WACC assessments also take into account comparable companies’ debt and equity ratings, as well as their cost of capital.
We can evaluate the worth of the subject company in comparison to similar companies after the WACC has been calculated and taken into account.
The income approach’s fundamental flaw in private company valuation is that the determined value is highly dependent on assumptions about the projection duration, cost of capital, and terminal growth rate. Any modest alterations to these fundamental assumptions will have a significant impact on the resulting value, which could be significant. Projections are problematic; assumptions about situations in the future, even if they are several years away, may or may not be accurate. As a result, for established enterprises with predictable, stable cash flows, income-based appraisals are the most dependable.
Several discounts must be considered and applied where applicable, regardless of the method used to estimate the subject private company’s valuation:
- Marketability discount: This discount considers the lack of ability to rapidly convert an ownership stake to cash.
- Discount for key personnel: This discount may or may not be available depending on the nature of the firm. Losing a key employee or leader may have little impact if the company is in a solid industry and is already well-established. However, if the company is young or a specific employee has a lot of value, the impact of that person leaving could be significant. The best example comes from Apple: Apple had a series of terrible years after Steve Jobs was driven out of the firm, only to rebound after Jobs was rehired. Without Steve Jobs, Apple’s worth was far lower than it was while he was in charge.
- Control discount: When selling a minority ownership in a private company, a value adjustment is required to account for the lack of operational and financial control. This can also apply in a public firm, but the impact will be considerably smaller; the impact in private companies will be much greater due to the lower amount of transparency associated with private corporations.
Although there are some obstacles in valuing a private company that are not present in valuing a publicly traded company, the methodologies for assessing value remain the same. While the information needed to estimate value may be more harder to come by and may necessitate some additional calculations depending on the valuation approach used, the principles for determining value that underpin each approach apply equally to private and public organizations. Due to the lack of transparency in private company financials, it may be necessary to employ multiple approaches to verify that your valuation estimate is correct and defensible.
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