Determining the market value of a publicly-traded company can be done by multiplying its stock price by its outstanding shares. That's easy enough. But the process for private companies isn't as straightforwardor transparent. Private companiesdon't report their financials publicly, andsince there's no stock listed on an exchange, it's oftendifficult to determine the value forthe company. Continue reading to find out more about private companies and some of the ways in which they're valued.
Key Takeaways
- Determining the value of public companies is much easier than private companies which don't make their financials available to the public.
- You can use the comparable company analysis approach, which involves looking for similar public companies.
- Using findings from a private company's closest public competitors, you can determine its value by using the EBITDA or enterprise value multiple.
- The discounted cash flow method requires estimating therevenue growth of the target firmby averaging the revenue growth rates of similar companies.
- All calculations are based on assumptions and estimations, and may not be accurate.
Why Value Private Companies?
Valuations are an important part of business, for companies themselves, but also for investors. For companies, valuations can help measure their progress and success, and can help them track their performance in the market compared to others. Investors can use valuations to help determine the worth of potential investments. They can do this by using data and information made public by a company. Regardless of who the valuation is for, it essentially describes the company's worth.
As we mentioned above, determining the value of a public company is relatively simpler compared to private companies. That's because of the amount of data and information made available by public companies.
Private vs. Public Ownership
The most obvious difference between privately-held and publicly-traded companies is that public firms have sold at least a portion of the firm's ownershipduring an initial public offering (IPO). An IPOgives outside shareholders an opportunity to purchasea stake in the company or equityin the form of stock. Once the company goes through its IPO, shares are then sold on the secondary market to the general pool of investors.
The ownership of private companies, on the other hand,remains in the hands of a select few shareholders. The list of owners typically includes the companies' founders, family members in the case of a family business, along with initial investors such as angel investors or venture capitalists. Private companies don't have the same requirements as public companies do for accounting standards. This makes it easier to report than if the company went public.
Private vs. Public Reporting
Public companies must adhere to accounting and reporting standards. These standards—stipulated by the Securities and Exchange Commission(SEC)—include reportingnumerous filings toshareholdersincluding annual andquarterly earnings reports and notices of insidertrading activity.
Private companies are not bound by such stringent regulations. This allows them to conduct business without having to worry so much about SEC policy and public shareholderperception. The lack of strict reporting requirementsis one ofthe majorreasonswhy private companiesremain private.
Raising Capital
Public Market
The biggest advantage of going public is the ability to tap the public financial marketsfor capital by issuing public shares or corporate bonds. Having access to such capital can allow public companies to raise funds to take on new projects or expand the business.
Owning Private Equity
Although private companies are not typically accessible to the average investor, there are times when private firmsmay need to raise capital. As a result, they may need to sell part of theownership in the company.For example, private companies may elect to offer employees the opportunity to purchase stock in the companyas compensation bymakingshares available for purchase.
Privately-held firms may alsoseek capital from private equity investments and venture capital. In such a case, those investingin a private company must be able to estimate the firm's value before making an investment decision. In the next section, we'll explore someof thevaluation methods of private companies used by investors.
Comparable Valuation of Firms
The most common way to estimate the value of a private company is to use comparable company analysis (CCA). This approach involves searching for publicly-traded companies thatmost closely resemble the private or target firm.
The process includes researching companies of the same industry, ideally a direct competitor,similar size, age, and growth rate. Typically,severalcompanies in theindustry are identified that are similar to the target firm. Once an industry group isestablished, averages of their valuations or multiples can becalculated to provide a sense of where the private company fits within its industry.
For example, if wewere trying to valuean equity stake in a mid-sized apparel retailer, wewould look for publiccompanies of similar size and stature with thetarget firm. Once the peer group is established, we would calculate the industry averages includingoperating margins, free-cash-flow and sales per square foot—an important metric in retail sales.
Private Equity Valuation Metrics
Equity valuation metrics must also be collected, including price-to-earnings, price-to-sales, price-to-book, andprice-to-free cash flow. TheEBITDAmultiple can help infinding the target firm'senterprise value (EV)—which is why it's also called the enterprise value multiple. This providesa much more accuratevaluation because it includes debt in its value calculation.
The enterprise multiple is calculated by dividing the enterprise value by the company's earnings before interest taxes, depreciation, and amortization (EBITDA). The company's enterprise value is sum of its market capitalization, value of debt, (minority interest, preferred shares subtracted from its cash and cash equivalents.
If the target firm operates in an industry that has seen recent acquisitions, corporate mergers, or IPOs, we can use the financial information from thosetransactions to calculate avaluation. Sinceinvestment bankers and corporate finance teams have already determined the value of the target's closest competitors, we can use their findings to analyze companieswithcomparable marketshareto come up with an estimate of the target's firm's valuation.
While no two firms are the same, by consolidating and averaging thedata from the comparable company analysis,we can determine how the target firm compares to the publicly-traded peer group. From there, we'rein a better positiontoestimatethe target firm'svalue.
Estimating Discounted Cash Flow
The discounted cash flowmethod ofvaluing a private company, the discounted cash flow of similar companies in the peer group is calculated and applied to the target firm. The firststep involves estimating therevenue growth of the target firmby averaging the revenue growth rates of the companies in the peer group.
This can often be a challenge for private companies due to the company's stage in its lifecycle and management's accounting methods. Since private companies are not held to the same stringent accounting standards as public firms, private firms' accounting statements often differ significantly and may include some personal expenses along with business expenses—not uncommon in smaller family-owned businesses—along with owner salaries, which will also include the payment of dividends to ownership.
Once revenuehasbeen estimated, we can estimateexpected changes in operating costs, taxes and working capital. Free cash flow can then be calculated. This providesthe operating cashremaining after capital expenditureshave been deducted. Free cash flow is typically used by investors to determine how much money is available to give back to shareholders in, for example, the form of dividends.
Calculating Beta for Private Firms
The next step would be to calculate the peer group'saverage beta,tax rates, and debt-to-equity (D/E) ratios. Ultimately, the weighted average cost of capital (WACC) needs to be calculated. The WACCcalculatesthe average cost of capital whether it'sfinanced through debt andequity.
The cost of equity can be estimated using the Capital Asset Pricing Model (CAPM). Thecost of debt will often be determined by examining the target's credit history to determine the interest rates being charged to the firm. The capital structure details including the debt and equity weightings, as well as thecost of capital from the peer group also needto be factored into the WACCcalculations.
Determining Capital Structure
Although determining the target's capital structure can be difficult, industry averages can help in the calculations. However, it'slikely that the costs of equity and debt for the private firm will be higher than its publicly-traded counterparts, so slight adjustments may be required to the average corporate structure to account for these inflated costs. Often, a premium is added to the cost of equity for a private firm to compensate for the lack of liquidity in holding an equity position in the firm.
Once the appropriate capital structure has been estimated, the WACC can becalculated. The WACCprovidesthe discount ratefor the target firm so that bydiscounting the target's estimated cash flows, we can establisha fair valueofthe private firm. The illiquidity premium, as previously mentioned, can also be added to the discount rate to compensate potential investors for the private investment.
Private company valuations may not be accurate because they rely on assumptions and estimations.
Problems With Private Company Valuations
While there may be some valid ways we can value private companies, it isn't an exact science. That's because these calculations are merely based on a series of assumptions and estimates. Moreover, there may be certain one-time events that may affect a comparable firm, which can sway a private company's valuation. These kinds of circ*mstances are often hard to factor in and generally require more reliability. Public company valuations, on the other hand, tend to be much more concrete because their values are based on actual data.
The Bottom Line
As you can see, the valuation of a private firm is full of assumptions, best guess estimates, and industry averages. With the lack of transparencyinvolved in privately-held companies, it'sa difficult task to place a reliable value on such businesses. Several other methods exist that are used in the private equity industry and by corporate finance advisory teams to determine thevaluations of private companies.
