By Tristan Van Iersel.
What are the process and the set of procedures used to estimate the economic value of an owner’s interest in a company? What is the price that you are willing to pay or receive to affect a sale of a company?
This article provides the main guidelines to value a private company.
Definition
In the following the private companies include sole proprietorships, privately held corporations, and previously public companies that have been taken private.
Reasons for valuing a company
There are three reasons for valuing the total capital and/or equity capital of private companies: transactions, compliance, and litigation.
Transaction-related valuations are necessary when selling or financing a firm: Venture capital financing, initial public offering (IPO), sale in an acquisition, bankruptcy proceedings, performance-based managerial compensation
Compliance-related valuations are performed for legal or regulatory reasons and primarily focus on financial reporting and tax issues.
Litigation-related valuations may be required for shareholder suits, damage claims, lost profit claims, or divorce settlement
Private company valuation approaches
There are three major approaches to value private companies:
Income approach: Values a firm as the present value of its future income. It relies on different assumptions and variations.
Market approach: Values a firm using the price multiples based on recent market transactions.
Asset-based approach: Values a firm’s assets minus its liabilities.
The selection of an appropriate valuation method depends on the firm’s operations and its life cycle stage. For Early stage companies, future cash flows may be subject to uncertainty and we may use an asset-based approach. For high growth companies, we might use an income approach. For mature companies, we might pick the market approach.
Income approach
Normalized earnings
In the income approach the appropriate earnings definition is normalized earnings that are calculated by adjusting for:
Nonrecurring and unusual items;
Discretionary expenses
Non-market levels of compensation;
Personal expenses charged to the company;
Real estate expenses based on historical cost;
Non-market lease rates.
Normalized earnings must take into account that the transaction for the buyer is either strategic or financial. In a strategic transaction, valuation is based in part on the perceived synergies with the acquirer’s other assets. In that case, the valuation has to incorporate any synergies as an increase in revenues or as a reduction in costs. While in a financial transaction, there is no synergy.
Estimating Cash Flow
Calculating free cash flow to the firm or to equity holders can be particularly challenging due to the uncertain cash flows and figures that comes from owner’s perspective that could bias the valuation. The crucial step is to estimate the different growth rates: a slide change in theirs values will modify drastically the valuation.
If there is significant uncertainty about future operations, we may examine several scenarios. For each of them, we assign a discount rate and probability based on the scenario’s risk and probability of occurring.
Estimating Discount Rate (Required return on equity)
The discount rate takes into account not just the time value of money, but also the risk or uncertainty of future cash flows; the greater the uncertainty of future cash flows, the higher the discount rate. As for the growth rates, an accurate estimation of the required return on equity is necessary to not bias the valuation.
Three ways to estimate the discount rate:
Capital Asset Pricing Model (CAPM): may not be appropriate for private companies as beta is usually estimated from public companies returns.
Expanded CAPM: adds premiums for size and firm-specific risk.
Build-up method: adds industry risk and other risk premiums to market rate of return and is used when betas for comparable public companies are not available.
Method 1 – Free cash flow
Once free cash flows have been estimated they are discounted by a rate that reflects their risk. Typically, there is a series of discrete cash flows and a terminal value that reflects the value of the business as a going concern at some future date. The terminal value is calculated for a time in the future for which the growth rate is expected to remain constant (mostly after 5 years).
Method 2 – Capitalized cash flow
This method is mostly used for small private companies when projections are quite uncertain and stable growth is a reasonable assumption.
Method 3 – Excess Earnings
The excess earnings method is used only for small firms with significant intangible assets.
With all methods above, if we have estimated the value of the equity, we must add the market value of the company’s debt to get the company’s value.
Market approach
Market approaches use price multiples and data from previous public and private transactions.
Private companies may have risks not common to public companies such as greater company risk and illiquidity. Therefore, the selection of the comparable public companies must be done carefully (same industry, operations, size, life cycle, etc.). The price multiples reflect both risk and growth. Each of these should be compared to the private company to decide what adjustments must be made.
Price multiple valuations for private company will mostly be based on the EBIT or EBITDA multiples. The numerator would be the market value of the invested capital (MVIC) from which the market value of debt could be subtracted when examining equity value. In case of low financial leverage, the book value may be used instead.
There are three methods for the market approach:
Guideline public company method: uses price multiples from traded public companies with adjustments for risk differences.
Guideline transactions method: uses price multiples from the sale of whole public and private companies with adjustments for risk differences.
Prior transaction Method: uses transactions data from the stock of the actual subject company and is most appropriate when valuing minority (non-controlling) interests.
Asset-based approach
The asset-based approach estimates the value of the company as the fair value of its assets minus the fair value of its liabilities. It not usually used for going concerns but for troubled companies, finance firms, investments companies, firms with few intangible assets, and natural resources firms.
Valuation Adjustments
In general, some adjustments are required when the liquidity or control position of an acquisition differs from that of the comparable companies.
Discount for lack of control
Minority shareholders are at a disadvantage relative to controlling shareholders because they have less power to determine the investment and pay-out policies that affect the value of the firm and the distribution of earnings. In this case, we may use a discount factor to translate the lack of control.
Discount for lack of marketability/liquidity
If an interest in a company cannot be easily sold, discounts for lack of marketability (liquidity) would be applied.
Conclusion
Private company valuation is an art in making appropriate assumptions. The valuation process requires to have a deep understanding of the company’s strategy, capabilities and external factors. A strong financial background combined with knowledge of the market in which the company operates are the minimum requirements to estimate the company’s value.
Article written by Tristan Van Iersel
Source: CFA curriculum 2015
