Private Company Valuation Methods
There’s more than one way to value a company, and no one method is more accurate than another. The valuation exercise starts by utilizing multiple methods to narrow in on a number range. While intuitively it makes sense that all valuation paths lead to the same end result, the reality is that once the numbers have been crunched, a banker is most likely going to end up with a handful of independent, estimated values for a business.
That’s where the real work begins. A banker or valuation expert will look carefully at the ranges of valuation that different methods produce and use qualitative, subjective insight to distill a company’s various valuation estimates into a single range that makes sense. For each method of valuation, a variety of non-quantitative factors are considered and valuation is adjusted accordingly.
There are three major concepts to understand when it comes to some of the most common valuation methodologies:
1. Discounted Cash Flow
The Discounted Cash Flow (DCF) business valuation model is a powerful tool grounded in a simple concept: the value of any given business is equal to the sum of all future cash flows of that business, discounted to reflect their value today. This valuation is only as good as the assumptions used to create the inputs. There is huge amount of discretion in projecting what a company’s business will look like for the next 5-10 years.
When applying the DCF model to a private company, assumptions will be made about that company’s cash flow, discount rates, control premiums and illiquidity discounts.
→ Cash Flow Estimation
Investors and bankers are especially careful when making projections about a private company’s cash flow because their history is almost always more obscure than publicly traded companies. Private firms are typically younger, do not face the accounting and information sharing requirements the public firms do, and sometimes do not account for the true cost of running a business. For example, an entrepreneur that founded a private business might work for a below-market wage prior to the sale of the company.
Particularly if you are a younger company, you will have to rely heavily on assumptions and may need to adjust accounting principles for the purposes of this analysis. Idiosyncrasies of small private companies must be included in the cash flow estimations as well. What if the founder will leave after the sale? Does his current salary reflect the true cost of replacing him?
→ Discount Rate Estimation
The discount rate is the rate of return the investor requires from this investment. If he perceives the investment is relatively risky, he will require a higher discount rate.
When valuing public companies it’s assumed the investor is properly diversified. This eliminates some of the risk of the investment. With a private company no such assumption can be made. For example, the investor might be a private equity fund specializing in a specific sector and making an investment in that sector.
Discount rates should also typically be higher for a private firm than a public firm because of a difference in expected longevity. With public companies, there’s an assumption that the business will continue indefinitely. Smaller private companies with a key founder involved in operations have a shorter expected lifespan.
→ Control Premium & Illiquidity Discount
There are a couple other key items that should be taken into account for a DCF valuation of a private firm. One increases its value (applies a premium), the other decreases it (applies a discount).
The premium derives from control and the value that control can realize. Unlike most purchases of shares in publicly traded firms, the purchase of a private company often comes with a great deal of control over the company. If the business is poorly run and the investor believes he can improve financial performance by exercising their power to change management, there will be a significant control premium.
While the transaction costs to buy and sell shares in a public firm are virtually nil; the resources and time required to buy and sell a private company are significant. The DCF valuation should account for these costs. This illiquidity discount is widely attributed for the 20% to 30% price discount sales of private companies exhibit relative to sales of public companies with comparable financial performance.
DCF valuations can be a powerful tool if used properly, but also have serious limitations. We discussed above the difficulty of properly estimating cash flows from a private company. Estimating a trustworthy discount rate is not an easy matter either. These issues are compounded because tiny changes to the inputs of a DCF valuation can have big effects. Discounted cash flow models often assume a business will operate for a long or infinite period of time. A tiny change in the growth rates of cash flows or discount rate can cause a huge swing in value.
Most buyers, as they start to negotiate with you, are going to attack many of the assumptions made about future growth. Help your banker understand which line items are highly predictable and which you believe are more variable. You’ll be able to get a better valuation for your business and help them in negotiation with a buyer
- Trading ComparablesBankers typically love using trading comp multiples to determine valuation because they reflect real-time, real-world valuation data. Trading comp valuations determine the current value of a company using a sample of ratios from a comparable peer group of publicly traded companies.
The key consideration here is to make sure you have the right universe of peer companies – companies that are the closest reflection to you in terms of size, product mix, growth potential, etc. Bankers will ideally look at a peer group of somewhere between 5-15 businesses. Rather than simply looking at the group average, a smart banker will focus on the companies that look most like your business and consider these companies’ multiples more heavily than the group’s average.
Helping your banker understand the key differences between the peer group and your firm can help him or her understand which companies are most relevant and will have the biggest impact on the valuation of your business.
3. Transaction Comparables
Comparable transactions considers the past sales of similar companies as well as the market value of publicly traded firms that have an equivalent business model to the company being valued.
This is hit-or-miss as a method for reliable valuation. The challenge is that there are likely a limited number (if any) of truly comparable transactions for a banker to consider. Assuming a banker is able to compile a list of transactions that make sense, the data surrounding the transaction (such as purchase price) is rarely publicly available. When it is, a banker isn’t going to know what portion of the price paid was standalone valuation and what portion was attributable to other factors (synergies, control premiums, etc.).
Finally, recency matters – market conditions, industries, etc. change. So, depending on what’s available, transaction comps can run the gamut from being virtually ignored in a valuation process to being a lynchpin in a negotiation of value.
Helping A Banker Understand Your Company
Often, as an industry insider, you’ll have information about recent company acquisitions that your banker isn’t aware of or doesn’t know much about. By filling him in with as many details as possible, he can build a more realistic model for your business. No valuation method will ever truly account for all the unique attributes and idiosyncrasies of a business. The best a banker can do is account for as many variables as possible and settle on a range that makes the most sense. By staying involved in the process and providing information your banker may not have access to you can ensure you’re getting the most realistic valuation range. And, though your banker is going to do their best analysis to predict an accurate valuation range for your company, remember that valuation is never perfect and that the only true way to find out the value of your business at any given point in time is to approach the market of potential buyers completely comprehensively with an excellent presentation of your business. That is the one final say on your company’s valuation — the price that the market of buyers is willing to pay.
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