Valuing Privately-Owned Companies:

Valuation Techniques

This note was written by Steve Pesenti, Research Associate, under the supervision of
Robert M. Johnson, Lecturer in Entrepreneurship. It has been prepared as a basis for
class discussion rather than to illustrate either the effective or ineffective handling of an
administrative situation.

Copyright © 1993. Revised January 2007. London Business School.

All rights reserved. No part of this case study may be reproduced, stored London Business
in a retrieval system, or transmitted in any form or by any means, School reference
electronic, mechanical, photocopying, recording or otherwise without CS94-037-02
CS 94-007
written permission of London Business School.
Contents

Introduction 3

1. The Valuation Context 3

Part Ia: Value for a Financial Investor – Ground Rules 3

2. Valuation and Financial Structure 4

2.1 Gain to Gearing
2.2 Minority Interests and Shareholder Lists

Part Ib: Value for a Financial Investor – Valuation Methods 6

3. Multiples 6
3.1 The Justification for Multiples
3.2 The Problem of Comparability
3.3 Which Multiple?
P/E Multiple; EBIT Multiple; Free Cash Flow Multiple; Historic and
Prospective Multiples; Other Multiples

4. Discounted Cash Flow 12

4.1 Applying Discounted Cash Flow Methods
4.2 High Risk Investments – The Venture Capital Method

5. Assets 15
5.1 The Balance Sheet
Fixed Assets and Non-operating Assets; Working Capital; Borrowings and
Other Liabilities; Assets not on the Balance Sheet
5.2 The Asset Audit
5.3 The Uncertainty of Asset Valuations

6. Which Method? 19

Part II: Value for a Strategic Investor 20

7. The Strategic Valuation Framework 20

7.1 Market Valuation
7.2 Direct Valuation
7.3 Fixing the Deal Price

Part III: Conclusions 21

8. The Vagaries of the Market 21

9. A Final Note 22

Bibliography 36

Valuing Privately-Owned Companies: 2

Valuation Techniques
Introduction
It is commonly said that the valuation of
companies is more of an art than a science.
The essence of this statement is that
arriving at a valuation is a matter of
judgement, balancing the consideration of
various factors, rather than the mechanical
application of a mathematical formula. This
is especially true when trying to value an
unquoted (privately-owned) company.
However, this does not mean that valuation
is a purely subjective exercise, where
different figures arrived at by different
routes may be regarded as equally valid.
From the valuer’s perspective some
approaches may clearly be a better guide
to value than others in specific situations.
The skill of valuation lies in assessing the
relative appropriateness of differing
valuation benchmarks to a particular
situation.
There are many papers providing detailed
expositions of the mechanics of particular
valuation methods. The purpose of this
note is to provide a perspective on
commonly used valuation techniques by
discussing their relative advantages,
limitations and pitfalls. It begins with a
review of pertinent financial theory and then
moves on to discuss the application of
various valuation methods. The reader
should be left with a better understanding of
the basic techniques and how to apply
them in a particular situation.
1. The Valuation Context
There are no absolutes in valuation.
Therefore, at the outset it is important to
ask why a company is being valued. The
circumstances of the valuation and its
purpose will influence the figure eventually
arrived at. Clearly the perspective of the
valuer is important. An important distinction
can be made between financial and
strategic investors:
A financial investor will look at the company
as a stand-alone entity, basing his valuation
on the risk-adjusted financial returns he
Valuing Privately-Owned Companies:
Valuation Techniques
believes could be made from an investment
in the company. An investment must
compare favourably with other investment
opportunities offered by property, bonds or
other companies. A financial investor
generally has no particular situational
advantage. In theory, given the same
information and assumptions, he should not
place a higher value on the company than
any other financial investor.
A strategic investor is able to secure
additional value, over and above that
available to a financial investor, from an
investment stake in or full ownership of a
company. These additional gains derive
from synergies offering, for example,
economies of scale or scope, or longer
term opportunities of access to new
products or markets. The size and nature
of such gains will be specific to the
situation of the strategic investor. But in
principle a strategic investor, should one
exist, will usually place a higher value on a
company than a financial investor.
One approach to valuation, therefore, is to
consider what valuation a financial investor
might place on the company, and then, if
appropriate, to consider how much more a
strategic investor might be prepared to
offer. This is the framework adopted in this
note.
Another point to recognise is that private
companies range from the small family
business to the large management buy-out
close to flotation. The circumstances of
such companies are clearly very different.
The application of the valuation techniques
outlined in this note must pay regard to the
situation of the company being valued.
Part Ia: Value for a Financial
Investor – Ground Rules
Above it was stated that theoretically,
given the same information and
assumptions, one financial investor should
not place a higher value on the company
than any other financial investor.
However, in practice different financial
3
investors invariably arrive at significantly
different valuations. This can arise for two
main reasons. First, there may be a
conceptual difference of view as to what is
the best guide to value, such as assets or
earnings or what type of business the
company is involved in, and so on. These
judgements will determine the basis on
which the valuation is made. Second,
even if there is agreement on the valuation
basis, there will usually be differences in
the various assumptions made to arrive at
a particular figure. Some investors may
be better informed than others.
The individual valuer himself may wish to
consider two distinct valuations: one based
on the company as it presently is, and the
other based on potential future
performance should he invest and influence
change in the company. The gap between
these valuations could be regarded as
measuring the difference in perception of
the opportunity between the new investor
and existing shareholders. These two
figures might constitute the valuer’s range
for any negotiation to buy or to invest in the
company.
The astute valuer should recognise the
sensitivity of judgements and assumptions
on the valuation he derives. Yet, although
subjectivity comes into play, the validity of
the application and interpretation of any
individual valuation method can still be
placed under objective scrutiny.
Depending upon the individual
circumstances, some methods will be
clearly better than others; others may be
simply irrelevant or incorrect.
2. Valuation and Financial Structure
Companies can be financed in a variety of
different ways. However, in simple terms
all financing instruments can be broken
down into two classes – debt and equity.
Hence the value of a company can be
defined as follows:
Value of Company = Value of Debt +
Value of Equity
Valuing Privately-Owned Companies:
Valuation Techniques
Thus there are two main approaches to
valuing a company. Either it can be valued
directly by an approach that does not
explicitly consider the value of its financing
instruments, or the debt and the equity can
be valued separately and the company’s
value derived from the total. In many
instances, debt can be valued at, or close
to, its book or ‘face’ value, so the second
method essentially revolves around valuing
the equity. Either method is valid, but the
valuer must not mix them. He must be
clear about which approach he is adopting
when using a particular valuation
technique. However, since in principle both
methods should lead to the same answer,
the valuer may consider both approaches
independently to check his analysis.
A situation where debt may not be worth its
face value is when a company is in financial
difficulty. If a company cannot meet its
debt obligations the company may be worth
less as a going concern than the face value
of its debt. Any value its equity may have
will derive from the possibility that the
company might recover from its current
problems.
If the company is to be kept as a going
concern, such a situation may ultimately
have to be recognised by the debt-holders
in a debt rescheduling, write-down or debt-
to-equity conversion. Alternatively, the
company may be put into receivership. In
these circumstances the value of a
particular debt-holder’s position will depend
on the security, if any, attached to his loan
and his position in the pecking order vis-à-
vis other creditors.
2.1 Gain to Gearing
A further complication is the impact of
financial structure on value. Since interest
costs are tax deductible, there is a tax
advantage to debt versus equity finance. In
an all-equity financed company, the
government via the taxman can be
regarded as having an invisible stake in the
company. By introducing debt into the
4
structure, some earnings can be shielded
from the taxman and the value of the
government’s invisible stake is reduced to
the advantage of the equity owners (the
debt being valued at face value) (Exhibit 1).
Hence, the total value of debt plus equity is
higher than the company’s all-equity
financed valuation. This increase is known
as the ‘gain to gearing’.
Financial economists differ in their
estimation of the potential size of the gain
to gearing effect. First, by disputing the
nature of the investor population, their
marginal tax rates and thus the true tax
saving available – how should corporate
and personal taxes be considered?
Second, by different estimations of the risks
and costs of bankruptcy – prudently how
much debt finance can be taken on?
Financial theory thus values the net tax
saving in a single year from using debt
finance as:
T* x Value of Debt x Debt Interest Rate
If this absolute level of debt is maintained in
perpetuity, the gain to gearing (discounting
at a rate equal to the current gross interest
rate) is:
T* x Value of Debt
Where the effective tax rate, T*, lies
somewhere between:
0 < T* < 1 - (1-Tc)(1-Te)/(1-Td)
Where:
Tc = Corporate tax rate
Te = Personal tax on equity income
for the marginal lender switching
from equity to debt
Td = Personal tax on debt income for
the marginal lender
Most practitioners appear to believe in a tax
advantage to debt finance as long as
gearing levels are not excessive. Thus for
practical valuation purposes, in the case of
a full-tax paying company with a
Valuing Privately-Owned Companies:
Valuation Techniques
satisfactory interest cover, it seems
sensible to assume that the effective gain
to gearing tax rate, T*, is closer to the
higher bound.
The UK has an imputation tax system,
which avoids the double taxation of
dividends. Thus, assuming the marginal
lender is subject to basic UK tax rates (a
problematic assumption given the large
amount of UK money managed under
gross investment funds and the variety of
personal tax situations): Tc = 33%, Te =
0% and Td = 25%. The implied higher
bound for T* is thus 11 percent. The
smallness of this figure suggests that the
gain to gearing is perhaps of relatively
minor importance in the UK. However,
under different tax regimes, such as that in
the US, where Te may be closer to Td for
the marginal lender, the gain to gearing is
probably of greater significance. The
valuer should therefore always bear in mind
the potential impact of financial structure on
value when using different valuation
methods.
2.2 Minority Interests and Shareholder
Lists
The techniques outlined in this note focus
on the valuation of the whole company. It
should be noted, though, that the value of a
percentage equity stake may not be simply
related to this figure. One might assume
that if a 100 percent equity stake in a
company is worth 100, then
proportionately, a 10 percent equity stake,
say, is worth 10. This is usually not the
case for equity stakes in unquoted
companies. Under UK company law,
without specific rights enshrined in the
company’s memorandum or articles of
association, a minority position will have no
or limited rights to influence dividend
payments or other company actions. Even
a holding over 50 percent does not confer
full control (Exhibit 2).
The absence of such rights can drastically
reduce the value of the equity stake. An
illiquid minority stake receiving no dividends
5
may be practically worthless. For this
reason a professional venture capitalist
investing in a minority equity stake will
usually demand certain contractual rights to
protect his position, and may have
additional preferential rights over other
shareholders. He may also place a lower
than pro rata value on his stake.
Should their rights be protected, though,
smaller shareholders may actually benefit
from the presence of an independent
investor with a significant equity stake in
the business. Assuming he has the power
to influence management action, a large
shareholder has a larger incentive to
closely monitor the performance of the
company than other shareholders, since he
will accrue larger financial gains from any
improvements he can suggest. Thus the
presence of a ‘hands-on’ investor with a
large stake can boost the value of the
business for all shareholders.
Part Ib: Value For A Financial
Investor – Valuation Methods
There are essentially three main valuation
methods commonly used by financial
investors:
Multiples
Discounted Cash Flows
Assets
We will look at each of these in turn.
3. Multiples
The multiple technique is relatively
straightforward. The valuer identifies one
or more companies, for which there is a
direct measure of market value,
‘comparable’ to the one being valued.
Typically this will mean looking at the
valuations of quoted companies with similar
businesses, but, should they be available,
private transaction valuations of similar
private companies made by other financial
investors may also be relevant. The value
is then measured in terms of its ratio to
Valuing Privately-Owned Companies:
Valuation Techniques
some measure of financial performance,
such as annual earnings before interest
and tax (EBIT). This ratio, ‘the multiple’, is
then applied to the same financial measure
of the company being valued, to derive a
comparative valuation.
For example, assume the valuer wishes to
value an engineering company that made
earnings before interest and tax of one
million pounds in its last financial year. He
selects a number of quoted companies in a
similar line of business and considers the
total market value of each company (debt
plus equity) in relation to its latest reported
EBIT. He finds that the Company
Value/EBIT multiples thus calculated range
from 8.0 to 12.0. By applying these
multiples to the engineering company’s
EBIT, he assesses its total value as 8-12 x
£1m = £8-12m. Having arrived at this
estimate, the valuer may now wish to refine
it by considering the values implied by other
multiples or by reconsidering his choice of
comparable companies.
Multiple valuations are seen by some as
rather unsophisticated and therefore of
limited use. However, the simple principle
underlying the multiple approach is to
estimate value by looking at the market
price of comparable companies. It would
be foolish to completely ignore a market
guideline should one exist.
3.1 The Justification for Multiples
All multiple methods ultimately derive their
theoretical justification from discounted
future cash flow models. In principle, the
multiple captures the market’s view of the
balance between the value of the future
cash flows deriving from both the existing
business plus other future growth
opportunities and the corresponding risk of
those cash flows.
An elementary definition of the commonly
used equity Price/Earnings (P/E) multiple,
taking earnings as a proxy for cash, is:
6

P/E = 1/r + PVGO/E
Where:
P = Price per share
E = Earnings per share
r = Equity real discount rate
PVGO = The net present value of
future growth opportunities per share
(discounted at r)
The formula above shows that the value of
the firm’s equity breaks down into two
components: a current earnings perpetuity
and the value of future positive net present
value (NPV) projects. Both factors are
represented in the P/E ratio and underlie
other multiples too.
The lower the risk and the larger the
proportionate NPV of future growth
opportunities to the firm’s current earnings,
the higher the P/E ratio. Thus the P/E ratio
is not only a function of the current earnings
growth rate but also how long this growth is
likely to continue and the investment in
fixed assets and working capital required to
fund it. These points are illustrated by the
simple model in Exhibit 3.
It should be noted that although the P/E
ratio is sometimes expressed in terms of a
dividend discount model, in principle the
value of the ratio itself is not a function of
dividend policy. The NPV of future growth
opportunities is independent of the choice
as to how they should be financed.
Generally, dividend policy should have no
effect on the value of the firm assuming
shareholders’ approval and influence over
the way retained earnings are reinvested in
the business.
Nevertheless, an outside party may regard
dividends as an indicator of a company’s
earnings strength and reinvestment needs.
Dividends may signal future growth
prospects and hence provide a guide to
value. To this extent dividend policy may
be important, particularly in the case of
publicly quoted companies. However, in
the case of a privately-owned company,
Valuing Privately-Owned Companies:
Valuation Techniques
current dividend policy may signal more
about the owners’ attitudes rather than the
company’s potential. Many private
companies never pay a dividend. A
potential investor needs to be clear about
his dividend, other income or capital
repayment rights since, when the means of
exit from the investment is unclear, these
will constitute his expected return.
3.2 The Problem of Comparability
When using similar companies to estimate
a benchmark multiple, the valuer is
assuming that companies involved in
similar businesses have similar levels of
business risk and growth opportunities.
The strength or weakness of the method
lies in the accurate assessment of
comparability between the benchmark and
the company being valued. Different
multiples are related to the company’s long-
term cash returns in different ways. Thus,
depending on the multiple used, different
detailed issues regarding comparability will
arise. Generally, though, a full appraisal
should consider the companies’ relative
levels of:
Profitability (Earnings/Sales), tax rates,
asset turnover (Sales/Capital Employed)
and return on capital employed
(Earnings/Capital Employed);
Growth prospects in terms of both
growth rates and the potential size of the
companies’ opportunities plus the level
of risk associated with them;
Debt capacity (if the gain to gearing is
important).
Often there may be no or very few
individual quoted companies with directly
comparable businesses. However, a
company may clearly fall within the
characteristics of an established quoted
industry sector. In these circumstances the
sector’s multiples may provide an adequate
benchmark even though no single company
has a strong similarity with the business.
7
Sometimes the multiple technique may
seem to be more a question of style over
substance. If, for example, the
pharmaceutical sector is trading on a higher
multiple than health care, by presenting a
company as primarily a pharmaceutical
business as opposed to a health care
business it might attract a higher valuation.
However, perceptions about current
fundamentals and future prospects are at
the heart of valuation, and stock market
fashions are clearly important when
considering flotation opportunities.
In the absence of domestic market
guidelines, overseas stock market
valuations might be considered, but care
needs to be taken over the impact of
different business conditions, accounting
policies, tax regimes and investor attitudes.
The valuer must ask how transferable is
any valuation derived in this way.
If the company is involved in more than one
kind of business, it may be appropriate to
consider it as a group of separate
businesses and use different comparable
multiples to value each part. However, the
valuer should also bear in mind that quoted
conglomerates generally trade at a
discount to their notional break-up value.
Unless there is an opportunity to break up
the company, this method may not be
appropriate.
Another problem arises in the use of
quoted valuations to value unquoted
companies. Small private companies
typically have fewer resources, leaving
them more exposed, for example, to
economic conditions or competitor action.
Moreover, equity investments in unquoted
companies are relatively illiquid, and many
unquoted companies are likely to remain
too small to ever float. Thus an investor’s
ability to exit will be governed by the
likelihood of finding a buyer down the road.
A discount compensating for illiquidity and
other factors may need to be applied to a
privately-owned company valuation derived
from a quoted multiple. Market perceptions
of this discount will vary; the only way to
Valuing Privately-Owned Companies:
Valuation Techniques
gauge its size is to look at recent unquoted
company deals (Exhibit 4). Minority equity
stakes may require an even larger
discount, depending upon rights contained
in the company’s memorandum or articles.
Sometimes the business will be unique. In
these circumstances one can only take an
imaginative guess about how the market
might value it. The multiple method is
inherently better at valuing the ordinary,
where there are many comparable
benchmarks, as opposed to the unusual,
where they may be few or none.
Businesses in new sectors or with
unusually high growth rates are more
difficult to value by direct multiple
techniques. Nonetheless, even in these
circumstances multiple methods can still
provide useful benchmarks.
3.3 Which Multiple?
Having chosen a suitable comparable
benchmark the valuer then has to decide
what type of multiple to use. What basis –
for example, earnings or cash and historic
or prospective figures – is it most
appropriate to apply a multiple to? The
best answer is to try a number of different
approaches. If they lead to similar figures
this should provide some reassurance to
the overall derived valuation. If there is a
wide scatter, the valuer will have to ask
why, and perhaps question the suitability of
his overall method or of certain types of
multiple.
The valuer should be clear about how to
calculate and apply different multiple bases.
Exhibit 5 shows how the values of different
multiples (mentioned below) for the same
company are derived and how they are
affected by financial structure. It should be
remembered that the multiple method
revolves around comparison with market
values. Thus multiples should be
calculated from market and not book values
of quoted benchmarks. In the case of debt,
book value may usually be taken as a good
proxy for market value, but this is not true
of equity.
8

P/E Multiple
The P/E multiple is defined as:
Value of Common Equity / Profit After Tax
and Minority Interests
Applying a P/E ratio to after-tax earnings
estimates the value of the equity, since
after-tax earnings are the net amount
accruing to shareholders. To estimate the
value of the whole company, the value of
the debt has to be added to the equity
value estimated by the P/E multiple.
The P/E multiple is commonly used as it is
easily available. The historic P/Es of
companies quoted on the UK stock market
are published daily in the Financial Times,
and stock market analysts commonly
produce prospective P/E estimates.
However, one complication with the P/E
method is that its value is a function of the
Debt/Equity gearing in the financial
structure (Exhibit 6). Thus a particular P/E
multiple is only appropriate to a specific
gearing level – implicitly measuring both its
impact on the risk of the equity earnings
stream plus the gain to gearing.
Thus if a benchmark P/E multiple is taken
from a company or group of companies
with a particular level of gearing, care must
be taken to apply this P/E to the after tax
earnings figure which the company being
valued would generate under the same
financial structure. Although possible, the
calculation is complicated by the fact that
the amount of debt the company would
have under the same financial structure
depends on the company’s value, which
the valuer is trying to estimate in the first
place.
Alternatively, by making an assumption
about the gain to gearing derived from the
financial structure, a notional all-equity
financed P/E may be derived for the
benchmark company. This multiple should
then be applied to an after tax earnings
figure assuming all-equity finance for the
target company. The additional value of
Valuing Privately-Owned Companies:
Valuation Techniques
any gain to gearing potential can be added
to this figure.
Care should also be taken over the
comparability of accounting conventions.
The multiple must be applied to
comparable earnings bases. Policies
regarding depreciation, amortisation and
the capitalization of expenses affect
reported earnings and should be
scrutinised for comparability. Additionally,
should a company earn income from
sources independent of its operational
activities, such as cash deposits or other
investments, these earnings and the assets
generating them should be excluded from
P/E calculations. Such assets should be
valued directly.
Finally, when estimating a P/E benchmark
or applying it, the valuer needs to be clear
that the earnings figures being used are a
fair reflection of ongoing earnings. Thus it
may be necessary to derive normalised
earnings figures rather than rely on
reported earnings. For example, are the
tax rates sustainable or is the level of
directors’ remuneration a fair reflection of
future management costs? Also recent
changes to UK accounting standards now
mean that one-off gains and losses are
included in reported post tax earnings – if
these are unlikely to recur in the future,
they should be excluded from the earnings
figures used.
EBIT Multiple
The EBIT (Earnings Before Interest and
Tax) multiple is defined as:
Value of Company / Earnings Before
Interest and Tax
Applying an EBIT multiple to earnings
before interest and tax estimates the value
of the company, since earnings before
interest and tax are a measure of the
income generated by the whole business.
The EBIT multiple method is popular since
it focuses directly on the growth and risk of
the business’s operational earnings, valuing
9
them directly without bringing in the
complications of choices about financial
structure. This approach is not entirely
foolproof since, if there is a gain to gearing,
the EBIT multiple will still vary with financial
structure. However, the EBIT multiple is
less sensitive to financial structure than the
P/E multiple (Exhibit 6). Unlike P/E
multiples, at a first approximation in many
cases, financial structure can be ignored in
simple EBIT multiple valuations.
As with P/E multiples, care needs to be
taken over the comparability of accounting
conventions between the companies used
to derive an EBIT multiple benchmark and
the EBIT earnings base to be valued.
Investment income should also be
excluded from calculations and the
associated assets valued directly. In
addition, although taxes do not affect the
EBIT figure, the method implicitly assumes
that the companies being compared are
subject to similar tax rates. Should this not
be the case proportionate adjustments
corresponding to long term ongoing tax
differences need to be made if the
discrepancy is large. In these
circumstances it may be simpler to use the
P/E method. Finally, as in the case of P/E
multiples, it may be appropriate to make
adjustments to reported earnings to take
account of non-recurring gains or losses.
Free Cash Flow Multiple
The Free Cash Flow Multiple is defined as:
Value of Company / Free cash flow after
tax but before interest generated by
operations before discretionary expenditure
Applying a free cash flow multiple to the
free cash flow generated by operations
estimates the value of the company. The
company’s ability to reward its financiers is
dependent on its free cash flow, which in
turn will determine the value they place on
the company.
Tax is included in the definition so as not to
mix pre-tax and post-tax cash flows.
However, the definition also means that the
Valuing Privately-Owned Companies:
Valuation Techniques
free cash flow multiple will change with
financial structure even if there is no gain to
gearing. Fortunately, in many cases the
variation will not be large. Nonetheless, if
the valuer is concerned by this, one
solution is to consider a notional all-equity
financed cash flow multiple as suggested in
the section on P/E multiples.
A multiple based on cash is closer to the
discounted cash flow justification of
multiples. However, the advantage of
earnings multiples is that accounting
principles allow earnings figures to smooth
out short term cash flow fluctuations.
However, sometimes the same principles
can obscure the situation. In these
circumstances the free cash flow multiple
may be more suitable. For example, a high
depreciation charge may hide the cash
generative potential of a mature business.
More generally, earnings do not measure
the reinvestment needed to support future
growth. Two companies with similar levels
of risk and earnings growth but different
marginal returns on capital employed will
have differing ratios of free cash flow to
earnings. Consideration of the free cash
flow multiple can be a useful check on true
comparability.
The free cash flow multiple is also
commonly used to get around the problem
of differing accounting conventions;
adjusting earnings figures to compensate
can be complicated, while a direct
estimation of current free cash flow may be
a simpler solution. Such an approach may
be particularly helpful when attempting to
compare companies based in various
countries each with its own accounting
standards.
Free cash flow after tax but before interest
can be estimated as the sum of the
following:
+ Normalised operating EBIT
(excluding one-off disposals,
identifiable discretionary expenses,
and so on)
10
+ Depreciation and other non-cash
expenses
- Tax (adjusting for effects of on-off
disposals, and so on)
- Increase in working capital
- Non-discretionary capital
expenditure
Discretionary expenditure consists of
expenses not associated with the
company’s ongoing business needs.
However, one difficulty with the method is
that it is not always easy to distinguish
discretionary from necessary expenditure.
Furthermore, in businesses with very long
investment cycles, cash flow can vary
dramatically from year to year and in a
profitable, high growth company free cash
flow may be small or even negative for
many years. In these situations a single
year’s snapshot cash flow figure is of little
significance. Also in some types of
businesses, small ones especially, changes
in working capital may fluctuate in a lumpy
fashion, distorting the true underlying level
of cash flow. In such situations a simple
‘cash flow multiple’ is sometimes
considered, which ignores the impact of
working capital changes and capital
expenditure.
Historic and Prospective Multiples
All the above multiples can be calculated
on a historic or a prospective basis as
follows:
Historic Multiple = Current Value / Reported
results for trailing year
Prospective Multiple = Current Value /
Estimated results for coming year
When using multiple valuations care must
always be taken to match like with like:
historic P/E to historic post-tax earnings,
prospective EBIT multiple to prospective
EBIT, and so on. Estimates of future
earnings are different from reported results
and the valuer must not mix them up. In
low or modest growth situations the
difference between historic and prospective
multiples will generally be small. In high
Valuing Privately-Owned Companies:
Valuation Techniques
growth situations differences will usually be
large, and applying the wrong multiple will
give incorrect valuations.
The reason for looking at both historic and
prospective multiples is that they provide an
estimate of how the market values growth.
If, for example, the company’s earnings or
cash flows are growing at a similar rate to
the benchmark’s, the historic and
prospective multiples will give similar
valuations; if not, the valuations will vary.
Should the difference in growth be large
and likely to persist, the benchmark is likely
to be inappropriate.
Using a large multiple associated with a
high growth company to value another high
growth company has additional
complications. A very high multiple is
driven more by the market’s perception of
the ultimate size of the company’s growth
opportunities rather than current short term
growth rates. A simple comparison of short
term growth rates will not reveal differences
in long term growth potential.
Other Multiples
Sometimes the company being valued will
not have a satisfactory earnings base to
apply a multiple to. Nonetheless, multiple
methods may still be able to provide an
estimate of potential value. In the case of
an early-stage company with major growth
prospects but currently making losses, the
simple multiple method is inappropriate.
However, a multiple method may provide a
guide to potential future value.
Alternatively, for the mature company
currently losing money, multiple methods
might provide a guide to the potential value
of a turnaround.
One approach to estimating potential value
is to take a direct stab at estimating the
likely level of future earnings and apply an
ordinary multiple. Alternatively, other
financial ratios such as Company Value /
Sales may be suitable. Another approach,
though, might look at other multiples
appropriate to the industry. For example
Company Value / Total Shop Area in the
11
retailing industry; Company Value / Number
of Rooms in the hotel industry; or Company
Value / Number of Subscribers in the cable
television industry. Clearly such multiples
are fraught with various assumptions, but
they can establish a simple measure of
potential upside.
Earnings multiples are often inappropriate
for valuing asset-backed businesses where
the assets can be valued directly, as in
property or investment companies. If
considering a flotation, the Asset Multiple
provides a measure of the market’s (usual)
discount to asset value:
Asset Multiple = Value of Company / Value
of Assets
Finally, some multiples make little
conceptual sense. For instance, earnings
after interest but before tax represent
neither a measure of the income to
shareholders nor the income generated by
the company, but something in between.
Neither the value of equity nor the value of
the company is clearly related to this
measure. If unusual multiples are used, the
valuer must be clear about the rationale
used to justify them.
4. Discounted Cash Flow
The discounted cash flow (DCF) method
requires the valuer to forecast the post-tax
free cash flows the business is expected to
require or generate in each future year and
discount them to arrive at a present value
of the income stream. This is the value of
the company. Within this generic approach
there are various standard methods of
arriving at the same result. In the case of a
private company, the simplest approach is
to value the whole company directly rather
than value the debt and equity separately.
This avoids the problem of having to
determine separate debt and equity
discount rates.
In principle, DCF methods of valuing the
whole company are complicated by the
gain to gearing influence of financial
Valuing Privately-Owned Companies:
Valuation Techniques
structure on value. Two alternative
approaches to this problem – the Additional
Present Value Method (APV) and the
Adjusted Cost of Capital Method – are
outlined in Exhibit 7. The Adjusted Cost of
Capital method is simpler, but the APV
method is more flexible and has the
advantage of separating the underlying
value of the business from the value
created by financial structure. It can also
be extended to value the gains from other
special allowances such as subsidised
loans, and so on.
The gain to gearing, however, is generally a
secondary effect. In comparison with other
uncertainties surrounding cash flow
projections or the choice of discount rate,
the complications surrounding proper
consideration of the gain to gearing may
seem beside the point. At a first cut, in
many instances it can be ignored without
changing the general picture. An all-equity
financed valuation may suffice.
4.1 Applying Discounted Cash Flow
Methods
The general advantage of DCF methods is
that they forecast the future growth of the
business and directly estimate the thing
that eventually returns value to the
investors, namely cash. Their
disadvantage is that they can become
overly complicated, sometimes
unnecessarily so, when an obsession with
the mechanics can obscure the real issues
and give a false sense precision.
The quality of the DCF valuation lies in the
quality of the forecasts. It is therefore
crucial to test the assumptions behind
them. For example, are the growth rates
and timescales believable? Is the implied
market share behind future sales
projections realistic? Are the margins and
returns on capital credible or sustainable in
the light of current benchmarks or future
competition from new entrants?
Consistency is also important; forecasts
12
should not mix nominal and real cash
flows1.
Top-down projections often underestimate
future working capital or capital expenditure
requirements, so the valuer should ensure
that these are realistically catered for. An
understanding of the business’s
fundamental economics is the mainstay of
good forecasts and is crucial when
conducting sensitivity analysis.
Additionally, a practical consideration
related to the valuation of cash flow
forecasts is, if the company generates
cash, to what extent are the shareholders
or other financiers assured rights to a
dividend or other income stream as
opposed to the company hoarding the
cash?
Another important decision is the choice of
discount rate, ra. Care should be taken to
use a nominal rate for nominal cash flow
forecasts or a real rate for real forecasts.
For an established company, the usual
textbook approach is to use the Capital
Asset Pricing Model (CAPM) to estimate a
rate of return for comparable quoted
companies and apply this.
In practice, though, such benchmarks will
change over time. Moreover, the illiquidity
of investments in private companies means
investors will add an ‘illiquidity premium’ to
the discount rate implied by the CAPM,
especially if the likelihood of exiting from
the investment is uncertain. The
appropriate level of the premium is very
much a rule of thumb.
Furthermore, simple DCF methods cannot
properly value a company’s options to
abandon or exploit new opportunities.
These can reduce risk and a ‘hands-on’
investor may be able to influence their
exercise. Overall, the uncertainties
surrounding both the level of future cash
flows and the rate used to discount them,
require that any value derived from a DCF
1 based on short term performance may be
Nominal forecasts include inflation expectations
whereas real forecasts are net of inflation.
Valuing Privately-Owned Companies:
Valuation Techniques
method be subjected to a sensitivity
analysis.
Even if the above issues are resolved, the
DCF method still leaves the problem of
estimating a terminal value. Although in
principle the DCF approach focuses on
yearly cash flow, forecasts can only look a
certain distance into the future. At the end
of the forecast period the ongoing business
will have a value. Therefore, to value the
company today the DCF method requires
an estimate of the terminal value of the
company at the end of the forecast period –
an assessment of its position and options
for the future.
A common practice is to apply a
benchmark multiple to the final year’s
forecast. Another approach is to apply a
free cash flow perpetuity-type formula. A
simple terminal-value formula, based on
constant profitability parameters and
depreciation equal to capital replacement,
is:
Terminal Value = S * m * (1 - g/R) / (ra - g)
Where: S = Sales for following year
m = Post-tax earnings margin
g = Long-term perpetual annual
sales growth rate
R = Post-tax return on capital
employed
ra = Asset rate of return
Other formulae may be more complex, but
in principle all are merely another way of
estimating a multiple. In many
circumstances the estimate of terminal
value may represent a significant proportion
of a valuation derived by the DCF method.
Thus in practice the DCF method does not
allow us to avoid the issues surrounding the
choice and use of a multiple (Exhibit 8).
The overall strength of the DCF method is
that it can provide some estimate of value
when the company is going through a
period of change and where measures
misleading. Examples might include: a
13
high growth company moving to maturity; a
turnaround situation; a start-up turning into
an established business; or a long term
investment programme expected to
generate revenues down the road. The
DCF approach captures the impact of the
change and the timings and uncertainties
associated with it. However, it cannot
circumvent the problem of needing to
directly value the company’s future growth
opportunities at the end of the period.
4.2 High Risk Investments – The
Venture Capital Method
The DCF approach underlies the venture
capital method for valuing high-risk
investments in start-ups or early-stage
companies. The projections for such
ventures typically follow the classic hockey
stick – initial losses and the consumption of
cash followed later by profits and cash
generation. There is nothing to value now,
just the prospect of a new business down
the road. The nature of such investments
is that, if successful, most of the returns will
be in the form of capital gains rather than
income. Thus, at a first approximation, the
return is a function of the terminal value of
the company created and the finance
required to get it started.
For example, suppose a start-up requires
half a million pounds of funding and the
projections suggest that after five years the
company will generate earnings of £1m p.a.
on a fully-taxed, all-equity financed basis.
A venture capitalist might estimate that the
proposed business would, when
established, attract a P/E valuation of 10,
and his required investment return for this
type of start-up is 50 percent p.a. His
current valuation of the business and the
amount of equity he will require for a half-
million-pound investment can be calculated
as follows:
Present value of company’s opportunity
(the ‘post-money valuation’):
(1m x 10) / (1 + 50%)5 = £1.3m
Valuing Privately-Owned Companies:
Valuation Techniques
Implied value of opportunity before £0.5m
financing (the ‘pre-money valuation’):
£1.3m - £0.5m = £0.8m
Venture capitalist’s required equity stake for
£0.5m investment:
£0.5m / £1.3m = 38%
Equity stake retained by existing
shareholders post investment:
£0.8m / £1.3m = 62%
The venture capitalist may choose to
provide the half a million pounds through a
financing package involving a variety of
instruments: ordinary shares, redeemable
preference shares, unsecured loan stock,
and so on. However, in a start-up or early-
stage investment all of the capital is at risk
and locked up in the company, regardless
of the instruments used. Different financial
structures do not alter the overall risk of this
kind of investment. What may be shown as
debt finance on the balance sheet is better
regarded, in terms of risk, as quasi-equity.
The venture capitalist will thus apply the 50
percent required return to the whole half-
million-pound package and not just to the
value of the ordinary equity slice.
Venture capitalists use very large discount
rates when valuing high-risk investments.
Typically early-stage or start-up projections
are discounted at 40-70 percent. With
rates of return at these levels, some of the
finer points of the DCF technique may
seem academic. Do they imply, after
allowing for an illiquidity premium, that
investments in high-risk projects have a
non-diversifiable risk around three to five
times that of the stock market? The likely
answer is no.
First, in some situations venture capital
finance may not be a commodity and the
high discount rate may partly compensate
the ‘hands-on’ venture capitalist for the
added value he brings. Second, and more
generally, so called ‘base case’ forecasts
14
presented by entrepreneurs are overly
optimistic, and the majority of early-stage or
start-up businesses fail. Thus the level of
expected cash flow returns is much smaller
than projections suggest. The high
discount rates practitioners apply to such
base case numbers are an expedient way
of compensating for this fact. These rates
are better seen as hurdle rates. If the
potential upside does not have the capacity
to deliver these levels of return, then it
cannot compensate for the more likely
downside of poor returns or losses.
DCF purists may prefer to consider a more
fundamental approach involving a realistic
estimation of the cash flow returns under
different scenarios, estimating a probability
for each to determine the net expected
cash flow returns and applying a discount
rate more akin to ordinary return levels, 30
percent, for instance (this figure is still well
above the actual internal rates of return
achieved by most venture capital funds
investing in start-up or early-stage
situations). This type of approach is used
by some venture capitalists.
In some situations it may be possible to
stage the funding based on specific
milestones; for example, test marketing
before a full launch. The company’s value
at each funding point can be viewed as the
value of the option to continue.
Consequently, today’s value can be
reduced to the value of a contingent option,
whose value can in turn be estimated by an
option tree calculation. However, even if in
principle the venture concerned lends itself
to this type of analysis, the approach can
get increasingly complicated as more
contingencies are added. The valuer must
always bear in mind a simple question:
given the problems in estimating all the
uncertainties, will the end result be
meaningful?
5. Assets
Multiples and DCF valuations are both
founded on future expectations. An
alternative approach is to look directly at
Valuing Privately-Owned Companies:
Valuation Techniques
the current value of the company’s assets
and liabilities by making a judgement about
the value of each asset and liability. Asset
valuation is a bottom-up method, so its
strength or weakness depends on how
clearly the value of the whole relates to the
sum of the parts. In practice, net asset
value – the book value of the equity – is
often the benchmark price for many private
company deals. Negotiation of the deal
price then reduces to scrutiny of the assets
and liabilities being purchased.
Multiple and DCF methods estimate the
value of the business as a going concern,
whereas the asset approach provides a
measure of its net value should it be wound
up. The asset valuation also provides a
guide to the company’s inherent
profitability, through return on capital
employed measures, and its financial
health: its need for further capital and its
ability to raise it. Although a business may
not be bought with the intention of winding
it up, the asset valuation can provide a
measure of the downside risk of purchasing
the company. Alternatively, scrutiny of the
assets can sometimes expose hidden value
or overstated value inside the company.
5.1 The Balance Sheet
The starting point for an asset valuation is
the company’s balance sheet. How closely
accounting numbers reflect actual value is
a key issue in asset valuation. The debate
over UK accounting standards splits into
two views of the balance sheet: one that it
should be a fair representation of current
value; the other that it should merely be a
summed record of past transactions.
Present accounting guidelines mean that
the balance sheet is a mixture of these two
approaches. For example, some assets,
such as property, are revalued regularly;
others, such as plant and machinery, are
recorded at historic cost and depreciated;
and some, such as brand names, are
(nearly always) excluded from the balance
sheet altogether.
15
Furthermore different accounting
conventions regarding depreciation or the
capitalization of expenses affect balance
sheet values. The valuer has to make his
own judgements about these conventions
and their correlation to the value of assets.
Book values and market values are often
not the same, so accounting numbers are
not an absolute guide to value. Moreover,
since value will often be dependent on
context, no single figure can be a guide to
value in all circumstances.
Conceptually the balance sheet can be split
into two parts, the capital employed in the
company and the sources of finance:
Capital Employed Financed By
Operating assets: Borrowings:
Fixed assets Debt
Working capital Leases, and so on
Non-operating assets Equity (= net asset value)
The company’s net asset value is the
balancing item between the value of its
assets and liabilities.
Fixed Assets and Non-operating Assets
Unless wound up, the company’s fixed
assets will not be liquidated en masse.
Nevertheless, an estimate of value may still
be important to the going concern
considering the possibility of selected fixed
asset disposals or investment in new
assets, or to the investor considering
alternative ways of entering an industry.
Non-operating assets, such as
investments, may be more readily
disposable assuming there is a market for
them.
Depending upon the situation and whether
assets are kept together or broken up,
valuations will differ. Book value is the
starting point. However, while accounting
depreciation attempts to measure the costs
of consuming a fixed asset retained over its
estimated useful life, it is not intended to
track changes in market values. Therefore,
depreciated historic cost, the conventional
accounting principle for most types of fixed
Valuing Privately-Owned Companies:
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asset, is a poor guide to actual value. First,
it ignores the impact of inflation. Second,
the asset, although serviceable, may
become obsolescent and lose value far
more quickly than the depreciation
schedule suggests. Or, alternatively, an old
asset may be written down to almost zero
but still be of use and thus retain significant
value. Third, the asset may be so
specialised that it only has a use in the
context of the company’s own operations
and thus has little value to a third party.
One valuation approach is to consider the
replacement cost of equivalent assets –
their new or second-hand market value or
the cost of replicating them. However, this
benchmark too may not always be a good
guide to value. Sometimes a business’s
assets may be over-specified or ‘gold
plated’ with little additional economic
benefit; for example, an over-powerful
computer system. An investor negotiating
on a net assets basis may not wish to
consider the gold plating as part of his
purchase price.
Alternatively, in some types of business the
fixed assets may be the essence of the
firm’s competitive position and earnings
potential; thus the firm’s value may derive
directly from its ownership of the asset.
This value may have little to do with the
asset’s simple replacement cost. For
example, the value of a strategic fixed
asset with characteristics of monopoly or
high barriers to competitor entry, such as
an airport, may be far greater than its
construction cost.
In other cases some existing assets would
not be built today since changes in
competition or technology have rendered
greenfield investment uneconomic.
Because ongoing costs are low in
comparison to high initial investment costs,
the assets already in existence may have
an economic value, but this will be below
replacement cost. It should be cheaper for
an investor to buy existing assets rather
than invest in new ones. Examples include
16
canals or plant in industries with significant
overcapacity.
Other assets, such as investments in other
companies, are not depreciated.
Depending on circumstances, these may
be held at book cost, net asset value or a
valuation set by third party. Their true
value may be uncertain. If significant, the
valuation of such items requires close
attention. Loans to other parties should be
carefully scrutinised. Are they likely to be
repaid?
For classes of assets where objective
market values are available, such as land
or property, UK accounting standards urge
regular revaluation on the balance sheet.
Clearly the more recent the valuation the
better the guide to current value. However,
even if a notional market value can be
established for any asset, the market may
be thin. Some asset disposals may be
hampered by a problem of illiquidity; it
might take a long time to find a buyer; and,
if a buyer is found, the disposal price may
differ significantly from the notional market
value.
Working Capital
Working capital is the money tied up in
short term assets and liabilities associated
with ongoing business activities: debtors,
stocks and creditors. Depending on the
type of business, working capital may be
positive or negative. The valuer needs to
be sure that the value of each element
making up the working capital requirement
is a fair reflection of the ongoing situation
so as to avoid unexpected write-offs or
holes that need to be filled with new capital.
In the case of debtors the valuer needs to
consider the possibility of bad debts. Have
adequate provisions been made to account
for this? The financial status of customers
and late payment schedules are useful
guides. In the case of late payers the
valuer needs to determine the company’s
leverage in collecting money owed.
Similarly, the level of creditors should be
examined. Are they being stretched
Valuing Privately-Owned Companies:
Valuation Techniques
beyond normal trading terms, thus
artificially depressing the working capital
requirement?
UK accounts value stocks on a first-in first-
out (FIFO) basis at cost, usually a
combination of direct and indirect costs.
The valuer needs to determine whether
stocks held are at a suitable level or mix to
support the ongoing business and whether
they are likely to be sold. Costs bear no
relationship to market value, and
obsolescent or slow-moving stock may be
of little or no value. Raw materials or work
in progress may also be of limited value
unless it can be converted into marketable
product. The value of stocks can be
ephemeral. If the business hits a turndown
in demand, stocks can rise, become slow
moving and, potentially, obsolete.
Realisable market value might not even
cover direct sales costs. Excess stocks
always require careful examination.
Borrowings and Other Liabilities
Most borrowings and other financing
related liabilities can usually be valued at
their face value shown on the balance
sheet. Although the balance sheet does not
record changes in value, such as the effect
of interest rate changes on the nominal
value of fixed-rate loans, such effects are
usually of secondary importance.
One area where face values can be
misleading is provisions (accruals against
possible future costs). The level of
provisions is a matter of judgement, and a
company can often be over- or under-
provided. The valuer must judge for
himself whether current provisions are a fair
reflection of future liabilities such as
restructuring costs, write-offs or potential
litigation actions.
The valuer must also ensure that he has a
comprehensive picture of the company’s
contracted liabilities. The company may be
committed to providing a product or service
in the future. It may even have already
received payment from a customer, in
17
which case the liability will be shown as a
deferred income creditor. The company
may have to incur additional costs to meet
these obligations and so future net asset
value will be influenced by whether they
can be met at a net profit or loss.
Commitments such as future operating
lease obligations are shown in the notes to
the accounts rather than on the face of the
balance sheet. These continuing
commitments are not normally included in
net asset value calculations, being
regarded as ongoing expenses; however,
they can also place constraints on the
business. Loan covenants or debentures
may also bring further restrictions. Other
commitments, such as forward foreign
exchange contracts, options or other
financial contracts are also shown in the
notes, but the information given can
sometimes be rather sketchy, hiding the
potential impact of such agreements.
Methods of hiding debt finance off-balance
sheet, such as limited recourse loan
guarantees to non-consolidated associates,
grew more popular in the 1980s. Recent
UK accounting changes have attempted to
close such loopholes. Inventive minds,
though, will always strive to find ways of
improving the appearance of the balance
sheet, and the valuer should be aware of
such ruses.
Assets not on the Balance Sheet
Brand names and patents are clearly a
major component of value for some types
of business and often, in principle, are
separable from the company. However,
the valuation of such assets is highly
subjective, due to the uncertainty about the
future revenues associated with them and
the relationship of these revenues to the
costs of creating and maintaining the asset.
This lack of clarity means that such assets
are generally excluded from UK balance
sheets. The valuer, though, cannot ignore
their existence.
Valuing Privately-Owned Companies:
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5.2 The Asset Audit
Having established a fair value for the
company’s assets and liabilities, the overall
structure of the balance sheet should be
considered. The valuer needs to review
the current position and assess how it
might change or be changed.
The valuer might begin by examining the
capital employed in the business. For
example, the company may own assets
surplus to its requirements. These might
include non-operating assets, such as
investments, or operating assets not
needed by the strategy for the ongoing
business. If the company were acquired, it
might be possible to sell these assets, so
reducing the net cost of the business.
Indeed assets can sometimes attract prices
well above book value. If so, the tax liability
crystallised on any disposal should not be
forgotten. Alternatively, the current fixed
assets might not be adequate to support
the ongoing business, implying a need for
additional capital expenditure. If the
business does not generate enough cash,
additional finance will need to be found.
Similarly the working capital position needs
to be reviewed. How does it compare with
the requirement of similar businesses? Is
the current level representative of future
needs: are creditors being squeezed, or
might it be possible to improve the
collection of debtors or reduce stocks?
How seasonal is the business, and what
impact does that have on the risks of using
debt to finance fluctuations in stocks?
What additional working capital will a
growing business demand?
Additionally, there may be choices about
how some fixed assets are financed. For
instance property or plant can perhaps be
owned or leased. These choices do not
affect total value but they do affect the way
value is tied up in the company and the
associated risks, current cash
requirements, future cash flows and
earnings.
18
The valuer should also consider the
implications of the company’s financial
structure: how healthy is the current trading
position and how strong is its balance
sheet? Should it require more cash, what
alternative sources of finance might be
available? Is the company’s gearing level
sustainable, or will it soon be in default?
How strong is its likely negotiating position
with its current financiers? The price of
investing in a company in financial distress
will often be reduced not only by an
uncertain trading environment but also by
the company’s need to do a deal quickly.
5.3 The Uncertainty of Asset Valuations
Asset valuations are often imbued with the
aura of precision. The above discussion
should make clear that this is a
misconception. Unless assets are cash or
near cash, there is always uncertainty
regarding their value. The value of
liabilities may be similarly uncertain. Even
if there is a clear value at the date of the
balance sheet, the valuer should be aware
that as trading continues the balance sheet
will change. Balance sheets can
sometimes deteriorate rapidly. Therefore
deals are usually subject to an up-to-date
accountant’s report.
6. Which Method?
Of the three methods described above (and
variations of the three), no single one is
best. In a few situations one method may
seem clearly superior. A profitable,
established professional services company
with few assets would suggest an earnings
multiple valuation. A property investment
company would suggest an asset valuation.
A high-growth, early-stage company with
no earnings and few marketable assets
would suggest a DCF valuation. However,
usually the choice of method is less clear-
cut.
On the surface, each of the three methods
seems very different, but on closer
inspection we find that they are all
interrelated. The DCF method still requires
Valuing Privately-Owned Companies:
Valuation Techniques
the estimate of a multiple. The asset
method still requires us to think about how
the assets will change over time and the
associated future cash flow and financing
demands. The multiple method requires an
assessment of comparability to which
balance sheet structures and accounting
conventions are directly relevant.
In practice a thorough valuation appraisal
requires the valuer to consider aspects of
each approach. Suppose a company owns
its property rather than rents it. Perhaps
the business should be valued on a
comparable multiple basis assuming it
rents an equivalent ordinary property with
the value of the specific property added on
top to find the total value of the company.
Or suppose the company is about to launch
a new product it believes will eventually
have a major impact on earnings. Perhaps
this income should be valued separately
using a DCF approach and the existing
earnings valued on a multiple basis.
Finally, suppose a company has a good
earnings stream but is poorly capitalised
and requires an injection of new cash.
Perhaps the company should be valued
simply on an earnings multiple basis less
the new cash requirement.
Different valuation approaches will clearly
result in a range of values rather than a
single number, and valuing a company in
different ways can sometimes produce
wide variations. It may seem naively
tempting to simply take an average to arrive
at a single figure, but this kind of approach
is unlikely to have merit. If different
valuation methods throw up wildly different
numbers, the first thing to do is to ask
‘Why?’. The answer may be that some of
the methods have used incorrect or
unrealistic assumptions and are plainly
wrong. Alternatively, each method may be
internally consistent, but collectively they
may be inconsistent in their assumptions
about the company’s current situation and
potential. Explicitly or implicitly, each
individual valuation carries its own
assumptions. Which one best captures the
valuer’s view?
19

Part II: Value For A Strategic
Investor
A strategic investor, should one exist, will
usually place a higher value on the
company than a financial investor. His
specific situation allows him to extract
additional value from the company over
and above that available to a financial
investor.
It is important not to confuse the strategic
investor with the trade investor. While it is
almost invariably true that strategic
investors are also trade investors, since
complementarity of businesses is generally
the basis for synergy gains, not all trade
investments are strategic. A trade investor
can also invest purely for financial reasons,
and therefore dealing with a trade investor
will not necessarily lead to a higher
valuation.
7. The Strategic Valuation Framework
The value to a strategic investor can be
considered thus:
Strategic Financial Value of
Investor’s = Investor’s + Synergy
Value Value Gains
This simple formulation makes clear that
the financial investor’s valuation is still
relevant for the strategic investor. Any
additional value that a strategic investor
ascribes to the company must be clearly
associated with synergy gains. When
confronted with a claimed strategic
valuation, it is a good discipline to work out
a financial valuation, determine the implied
synergy valuation, and then ask whether
the numbers are credible.
Valuing synergy gains in essence involves
the same valuation techniques employed
by financial investors. However, a strategic
valuation is specific to the situation of both
the company being valued and the acquiror
or investor. The figure arrived at is very
much driven by the latter’s perception of the
Valuing Privately-Owned Companies:
Valuation Techniques
nature of the synergy opportunities
available, some of which are easier to
grasp than others. The immediate
opportunities to increase revenues or
reduce costs through the coordination or
merger of two businesses may be relatively
clear. The value of options to exploit longer
term opportunities created by the
coordination of assets or skills may be
more difficult to define.
7.1 Market Valuation
Although the sources of strategic value in a
given situation may be specific, they are not
often unique. Market measures of strategic
value are therefore relevant. The best
guide to these are Mergers and
Acquisitions (M&A) valuation multiples
implied by recent deals involving
comparable companies. Yet M&A multiples
have their problems. The problems of true
comparability are even more intractable
with M&A data than they are with simple
stock market multiples; how equivalent are
the synergy gains? Furthermore, the terms
of many M&A deals are not disclosed, so
relevant sample sizes are sometimes very
small. Nonetheless, it makes sense to look
at the market’s view even if only because
others probably are doing it too. Because
of their constant involvement, M&A
advisers can be particularly helpful in
providing a market viewpoint and
interpreting variances in market values.
M&A multiples consider the comparable
deal valuation as a ratio of some other
measure. Earnings multiples are frequently
used, but often other measures can capture
more effectively the essence of the synergy
gains involved. For example:
‘Deal Price / Sales’ may be relevant to the
valuer expecting to acquire direct revenue
contribution with little net increase in his
overhead; ‘Deal Price / No. of Customers’
may be relevant to the valuer seeing the
acquisition as a means of selling new
products to the acquired customer base.
One problem with market based valuations
centres around the comparability question;
20
deals can sometimes be unique in terms of
either the business being valued or the
strategic fit between the parties.
Furthermore, perceptions about strategic
value change over time. Multiples based
on old deals may not be a fair reflection of
current market expectations. Even if they
are, there is a danger of the valuer relying
on others’ assessments rather than his
own. The strategic valuer must always
estimate directly the value of the synergy
gains he himself could achieve and use
market valuations as a guideline against
which to compare the direct valuation.
7.2 Direct Valuation
When assessing the value of synergy gains
the valuer must consider only those gains
that derive solely from the valuer’s ability to
control or influence the business through an
investment; that is, gains incremental to
those that could be realised by any other
route. For instance if the valuer is looking
at an acquisition as a means of buying a
customer list, he must ask to what extent
he could get those customers in any case
without the acquisition. If the acquisition
brings nothing that the valuer could not do
himself at a comparable price (timing
concerns considered), there may be no
synergy gain. Indeed, in certain
competitive situations one company may,
by competitive action, be able to lower the
notional financial investor valuation of
another company.
The three main valuation techniques are all
appropriate to valuing synergy gains by
applying them to the valuer’s assessment
of incremental benefit. For example, a
multiple could be applied to the anticipated
immediate increase in earnings. If the
benefits are longer term, a DCF valuation of
the incremental impact on cash flow and
future options might be appropriate.
Alternatively, if there is a major gain from
the combination of assets, a revised asset
valuation might be relevant.
Valuing Privately-Owned Companies:
Valuation Techniques
7.3 Fixing the Deal Price
Having made an assessment of the
synergy gains available, the strategic valuer
needs to work out how much he needs to
pay to achieve them. One point the valuer
should consider is what level of control is
consistent with achieving the anticipated
gains. In many situations this will mean
acquiring the company, but in others a joint
venture partnership or an equity stake
might be a suitable alternative. Using
different structures my have an impact on
the price that is paid and how future risks
are shared.
To make a deal worthwhile to the strategic
investor, the price clearly needs to be
below his assessment of the strategic
valuation, while the seller’s perceptions of
the value to a financial investor should set a
lower price bound. The final level at which
a price is struck partly comes down to the
competition for a deal – who else might be
interested in the deal, and what is the value
to them. The strategic investor’s ability to
get a ‘fair’ price or even a bargain will be
influenced by the uniqueness of his position
versus other buyers.
The price will also depend upon the seller’s
ability to create actual interest and
competition for a deal among potential
buyers. Small businesses are sometimes
too small to attract the attention or interest
of strategic buyers. In these circumstances
it is often important for the owner to grow
the company to a certain critical size before
considering a sale.
Part III: Conclusions
8. The Vagaries of the Market
To a greater or lesser extent, all the
valuation methods described rely on market
benchmarks. This can trouble some
people, who query whether the underlying
value of the company is really altered if, for
example, stock market benchmarks
change. Market prices reflect investor
perceptions about risk and return. They will
21
always form a guide for any third party
looking at a company, and thus cannot be
ignored. If an investor is thinking of selling
or floating a company now, their impact is
inescapable. If not, they still place limits on
others’ perceptions of future prospects and
value.
Should the valuer disagree with a market
valuation, he needs to think about how his
perceptions differ from those of the market,
and whether these differences are
defensible. Simply saying that the multiple
should be ten rather than seven is not
enough; the valuer needs to make a strong
case arguing that anticipated earnings
growth is greater or the earnings stream
less risky, and so on.
On the other hand, slavish acceptance of
market benchmarks can be dangerous. In
the late 1980s it became fashionable to
look at buy-out valuations in terms of the
prices paid and debt-equity structures used
in other buy-out deals. The problem with
this approach is that it can reduce to the
assertion that the value of a company
equates to the finance that can be raised
against it. This is clearly a tautology, and
the danger is that the valuer is in effect
relying on somebody else’s valuation rather
than his own. A multiple or any other
market benchmark is only a guide to value
and is not a determinant of it. It is always
necessary to take a step back from any
valuation and ask whether it makes sense
in terms of the valuer’s own expectations.
9. A Final Note
Despite all the foregoing analysis, the value
of a company today – either 100 percent
control or just an equity stake – is simply
what someone else would be prepared to
pay for it. Private companies are illiquid
investments and there may be few potential
investors or buyers around, especially for
small businesses that may be of little
interest to trade buyers as well as too small
to float. Thus the value depends as much
on finding the right investor/buyer and
exciting him about the business as anything
else.
At the end of the day arriving at the price of
a deal comes down to presentation and
negotiation, and the two biggest factors
may well be the level of competition (real or
perceived) among the potential investors
and the motivations of or pressures on the
seller. In practice the final price struck
often reflects the respective negotiating
abilities of the parties involved, and there
are no absolutes in that game. But in most
situations, if the price proposed does not
seem right, you can always walk away.

There will be times when the market is

taking an optimistic view, others when it is
pessimistic; and this will affect deal values.
There are windows of opportunity to buy or
sell companies, but these are easier to see
in hindsight. Recognising and seizing them
at the time is often a matter of luck. In most
businesses one will achieve consistent
investment returns by developing the
underlying business rather than by second-
guessing the market.

Valuing Privately-Owned Companies: 22

Valuation Techniques
Exhibit 1: Financial structure and gain to gearing

Gain to gearing

The above graph assumes that the gain to gearing is T* x Value of Debt, and that T* is 11
percent. A total value in excess of 100 results from the gain to gearing, which accrues to
equity holders. In practice, at high gearing levels the gain to gearing will fall and become
negative due to the limited size of taxable profits that can be shielded and the risks of
bankruptcy.

Valuing Privately-Owned Companies: 23

Valuation Techniques
Exhibit 2: Trigger Points affecting the Value to Shares in Private Companies

Percentage of Degree of Control and the Implications for an Equity Stake’s Pro-Rata
Equity Held Value

90-100% Effectively complete control since minority shares can be compulsorily bought.

75-89.9% Almost full control as enough to carry a special or extraordinary resolution2.

However, the existence of a troublesome minority shareholder may cause
some problems.

50.1-74.9% Effective control but leaves an exposure to a difficult minority able to block
special or extraordinary resolutions. Potentially worth less than 75 percent.

50% Potential stalemate if other shareholders act together in opposition, but

valuable if other shareholders are on your side. Likely to be worth much less
than 50.1 percent.

25.1-49.9% Likely to attract another big discount from 50 percent. But carries negative
rights through ability to block special or extraordinary resolutions.

10.1-25% Practically worthless, especially if no dividends are paid and majority

shareholder(s) freeze the minority out. Not very attractive to an outside
purchaser.

0-10% Similar to 10.1-25 percent, but can also be compulsorily purchased by a

shareholder with a 90 percent holding.

The actual impact of these trigger points on the value of a shareholding will depend very
much on the distribution of shares among other shareholders (is the balance held just by one
party or scattered amongst many?) and these other shareholders’ attitudes. Additionally,
there may be legal redress against the undue oppression of a minority.

2
A special or extraordinary resolution is required to authorise: a winding-up; an increase of authorised capital; an
increase in borrowing powers; an alteration of articles or memorandum; and any other situation specified in the
articles or memorandum.

Valuing Privately-Owned Companies: 24

Valuation Techniques
Exhibit 3: Factors affecting Multiples

A simple free cash flow or ‘dividend discount’ model can explore the factors affecting the level
of P/E multiples. Consider an all-equity financed company with:

Annual Sales =S
Annual Earnings after tax =E
Capital Employed during year =A
Sales growth = g% p.a. (in a stepwise
fashion)
Profit margin = E/S = m
Asset turnover = S/A = K
Return on Capital Employed (ROCE) = E/A = m * K

Where g, m and K are constant.

The free cash flow (FCF) generated during one year is:

FCF = Earnings - Investment in Capital Employed to support following year’s growth.

(Note: Earnings are assumed to carry a charge equal to the cash cost of maintaining the
company’s current capital stock.)

This can be rewritten as:

FCF = m * S - (1/K) * Anticipated Growth in Sales

FCF = m * S - (1/K) * [S * (1+g) - S]
FCF = E - (1/ROCE) * g * E

All other things being equal, free cash flow is lower the higher the growth rate, g, or the lower
the company’s ROCE. If g>ROCE, free cash flow is negative.

In the graphs illustrated on the following pages, the above formula is used to calculate the
company’s free cash flow in successive annual periods assuming a constant growth rate, g, for
a period of T years after the first year. After this time the company goes ex-growth (g=0%),
earning a constant amount in perpetuity. The company’s ROCE remains constant. Free cash
flows are paid to, or, if negative, raised from shareholders. These future cash flows are
discounted at a real rate of 12.5 percent p.a. to arrive at the net present value of the company.
The P/E ratio is obtained by dividing the company value by the first year’s prospective
earnings.

The model shows how the P/E ratio is a function of ROCE, g, T, as well as the discount rate (r).
Similar models can be used to study other multiples. For example, an analysis of the
Company Value / Sales multiple would show that this is a function of m, K, g, T, and r.

Valuing Privately-Owned Companies: 25

Valuation Techniques
Exhibit 3 (continued): P/E Multiples: The Impact of Growth Prospects

Growth and P/E multiples

The P/E ratios above are calculated for a range of growth rates, g, and for different growth
periods, T, where T = 5, 10 and 15 years. The company’s ROCE is 33 percent p.a.

If g=0% the company does not grow. It distributes all its earnings to shareholders. Its P/E ratio
is 8 (=1/Discount Rate). If g>0% the P/E ratio is higher as the company reinvests a proportion
of its earnings in positive NPV projects.

The variation with the value of T illustrates that a company with a lower annual growth rate but
good long-term growth prospects can have a higher P/E ratio than a company with a higher
short-term growth rate but smaller long-term growth opportunities.

Valuing Privately-Owned Companies: 26

Valuation Techniques
Exhibit 3 (continued) – P/E Multiples: the Impact of Reinvestment Needs

Return on capital employed and P/E multiples

The P/E ratios above are calculated for a range of growth rates, g, and for different ROCEs,
where ROCE = 12.5 percent, 20 percent, 33 percent and 100 percent p.a. The period, T,
before the company goes ex-growth is 10 years.

The company’s ROCE for new investment must be greater than the discount rate (12.5
percent), otherwise it destroys value. At a ROCE=12.5% the company’s P/E is 8 regardless of
the growth rate, g. If ROCE>12.5% the company can create value by investing in growth
opportunities.

The higher the company’s ROCE, the smaller the proportion of earnings it needs to reinvest to
support a given growth rate, g. It distributes more to or raises less from its shareholders.
Thus, all other things being equal, a higher ROCE will result in a higher P/E ratio.

Valuing Privately-Owned Companies: 27

Valuation Techniques
Exhibit 4: Private Company Versus Quoted Company Valuations

Acquisition prices of private companies versus UK stock market valuation

The Private Company Price Index (PCPI), compiled by Stoy Hayward and Acquisitions
Monthly, tracks the average price paid (as measured by the P/E multiple) in private company
acquisitions. Although an acquisition valuation is not directly comparable with a valuation of an
equity stake in a quoted company, the PCPI demonstrates that private companies are usually
valued at a discount to quoted companies, and, furthermore, that the size of this discount
fluctuates over time.

Valuing Privately-Owned Companies: 28

Valuation Techniques
Exhibit 5: Calculating Different Multiples

XYZ plc is a quoted company with no debt finance and capitalised at £100m. Historic and
prospective earnings forecasts for the past and coming year are outlined below (corporation
tax is 33 percent of accounting earnings). The company’s balance sheet shows £40m capital
employed.

Historic Prospective
£m £m

Sales 100.0 110.0

Gross profit 40.0 44.0

SG&A 16.0 17.0

Depreciation 4.0 4.4

EBIT 20.0 22.6

Tax 6.6 7.5

Post-tax earnings 13.4 15.1

Fixed asset investment 6.0 6.6

Working capital investment 2.0 2.2

Free cash flow (ATBI3) 9.4 10.7

EBIT + Depreciation – Tax - Investment)

The following multiples may be calculated for XYZ plc:

Multiple Historic Prospective

P/E 100/13.4 = 7.5 100/15.1 = 6.6

EBIT 100/20.0 = 5.0 100/22.6 = 4.4

Free cash flow (ATBI) 100/9.4 = 10.6 100/10.7 = 9.3

Sales 100/100 = 1.0 100/110 = 0.91

2
After tax and before interest.

Valuing Privately-Owned Companies: 29

Valuation Techniques
Exhibit 5 (continued): Calculating Different Multiples

Assume XYZ plc has a different financial structure in which it is partly financed by £30m of
debt carrying an annual interest rate of 10 percent. Assuming T* is 11 percent, the gain to
gearing will be £3.3m, so XYZ’s total value will now be £103.3m and its equity capitalisation
will be £73.3m (subtracting £30m debt from the total value). Revised historic and prospective
earnings forecasts for the past and coming year are outlined below.

Historic Prospective
£m £m

Sales 100.0 110.0

Gross profit 40.0 44.0

SG&A 16.0 17.0

Depreciation 4.0 4.4

EBIT 20.0 22.6

Interest 3.0 3.0

Profit before tax 17.0 19.6

Tax 5.6 6.5

Post-tax earnings 11.4 13.1

Fixed asset investment 6.0 6.6

Working capital investment 2.0 2.2

Free cash flow (ATBI) 10.4 11.7

EBIT + Depreciation – Tax = Investment)

Multiple Historic Prospective

P/E 73.3/11.4 = 6.4 73.3/13.1= 5.6

EBIT 103/20.0 = 5.2 103/22.6 = 4.6

Free cash flow (ATBI) 103/10.4 = 9.9 103/11.7 = 8.8

Sales 103/100 = 1.0 103/110 = 0.94

Valuing Privately-Owned Companies: 30

Valuation Techniques
Exhibit 6: P/E and EBIT Multiples – Sensitivity to Financial Structure

The impact of financial structure on multiples

An all-equity financed company has an EBIT multiple of 5 and a P/E multiple of 7.5, assuming
a corporate tax rate of 33 percent. The above graph shows how the company’s multiples
would change under different debt/equity financial structures. Due to the gain to gearing (T* is
assumed to be 11 percent) the EBIT multiple varies slightly. The P/E multiple is more sensitive
to financial structure, being affected not only by the gain to gearing but also by the change in
the risk of the equity earnings stream. The graph does not take account of the impact of
bankruptcy risk on the company’s value at high gearing levels.

Valuing Privately-Owned Companies: 31

Valuation Techniques
Exhibit 7: Discounted Cash Flow Valuation Methods

Five-year nominal post-tax free cash flow projections for ABC Ltd, assuming it is all-equity
financed, are as follows:

(£000s) Year 1 Year 2 Year 3 Year 4 Year 5

Free cash flow 100 120 142 164 187

After year five these flows are expected to grow further at 12 percent p.a.

Two methods of valuing ABC which include consideration of the gain to gearing are illustrated
below:

Additional Present Value (APV) Method

The company’s future post-tax free cash flows are forecast assuming it is all-equity financed
and then discounted at the expected rate of return, ra, of similar types of business. The present
value of these cash flows is the company’s value if all-equity financed.

Any additional present value created by the use of debt finance can be estimated directly by
assuming a specific sustainable debt policy and calculating the net additional cash flow gains
made by the company as a result of the tax saving. Assuming these gains to be certain, they
may be discounted at the company’s gross risk-free rate, rf, to calculate the gain to gearing.

Example

Assuming a 20 percent p.a. cost of capital for ABC’s type of business, ABC’s value at the end
of year 5 (the value of its free cash flows in year 6 and after) may be estimated by a growing
perpetuity:

Year 5 value = £0.187m x (1 + 12%) / (20% - 12%) = £2.62m

Thus, discounting the five-year free cash flow projections plus the year 5 value at 20 percent
p.a. gives a present value for ABC, assuming it is all-equity financed, of £1.46m.

Now instead assume that the company will be partly financed by £580,000 of debt (D) on an
ongoing basis. Assuming a 10 percent interest rate (i) and T*=11%, the yearly net tax saving
and the overall gain to gearing will be:

Yearly saving = T* x D x i = 11% x £580,000 x 10% = £6,380

Gain to gearing = T* x D = £63,800

Valuing Privately-Owned Companies: 32

Valuation Techniques
Exhibit 7 (continued): Discounted Cash Flow Valuation Methods

Thus ABC’s value under the proposed constant £0.58m debt structure is:

Total Company Value = £1.46m + £0.06m = £1.52m

Debt Value = £0.58m
Equity Value = £0.94m
Gain to Gearing = £0.06m
Gearing = 0.58/1.52 = 38%

Adjusted Cost of Capital Method

As above, the company’s post-tax free cash flows are forecast assuming it is all-equity
financed. These are discounted at an adjusted discount rate, r*, which assumes a sustainable
constant percentage gearing financial structure under which the company remains in a tax
paying situation.

r* = ra - Gearing x rf x T* x (1 + ra) / (1 + rf)

Where:
Gearing = Target ratio of: Debt / (Debt + Equity)
ra = Asset rate of return
rf = Gross risk-free rate
T* = Effective gain to gearing tax rate

Since the future absolute levels of debt are uncertain, r* discounts the tax savings using a risk
discount rate rather than rf. Overall the calculation provides a valuation of the company that
includes the gains from financial structure.

Example

Assume ABC’s debt policy is to maintain a constant level of gearing of 38 percent. The
adjusted cost of capital, r*, is therefore:

r* = 20% - 38% x 10% x 11% x 1.20 / 1.10 = 19.5%

The value of ABC at the end of year 5 under this debt structure is:

Year 5 value = £0.187m x (1 + 12%) / (19.5% - 12%) = £2.79m

Thus, discounting the five-year free cash flow projections plus the new year 5 value at 19.5
percent gives a present value for ABC, assuming a constant 38 percent gearing, of £1.55m.

Thus under a constant 38 percent geared debt structure:

Total Company Value = £1.55m

Gain to Gearing = £0.09m
Debt Value = £0.59m
Equity Value = £0.96m

Valuing Privately-Owned Companies: 33

Valuation Techniques
Exhibit 7 (continued): Discounted Cash Flow Valuation Methods

Comparing the Results

The two calculations give slightly different results. The differences essentially result from:

1. Different assumptions about debt policy underlying each calculation that affect the size
of the tax savings available.

2. Differing degrees of uncertainty regarding the tax savings available that affect the rate
at which tax savings are discounted.

However, both calculations show that the gain to gearing, assuming that T*=11%, only has a
minor effect on total company value. In the light of other uncertainties, overly complicated
calculations may not be meaningful.

Valuing Privately-Owned Companies: 34

Valuation Techniques
Exhibit 8: The Impact of Terminal Value on DCF Valuations

The components of a company’s present value

The above illustration uses the same discount model as in Exhibit 3. The company’s growth
period, T, before it goes ex-growth is 10 years, its ROCE is 33 percent p.a. and the real
discount rate is 12.5 percent.

The absolute value created (not shown) depends on the growth rate, g. The company’s
present value when g=50% is over 15 times that when g=0%. But the figure above shows how
the company’s present value is proportionately composed of the present value of: the first five
years’ free cash flows, the second five years’ free cash flows and the terminal value in year 10.

The relative size of the terminal value element as a proportion of total value depends on the
growth rate. A higher growth company retains more of its earnings, therefore the present value
of the free cash flows generated during the 10-year growth period is smaller in relation to the
present value of the company eventually established. At very high growth rates (g>ROCE) the
company consumes cash to grow and the terminal value contribution represents more than
100 percent of the present value. However, even at low growth rates, the year 10 terminal
value is still a major component of today’s total value.

Valuing Privately-Owned Companies: 35

Valuation Techniques
Bibliography

Principles of Corporate Finance, Richard A. Brearley and Stewart C. Myers, (McGraw Hill)

This classic finance textbook contains detailed discussions of the theory and practice behind
the gain to gearing and discounted cash flow techniques.

Note on Free Cash Flow Valuation Models: Identifying the Critical Factors that Affect Value,
(Harvard Business School)

A note illustrating the various factors affecting discounted cash flow valuations by means of a
simple model.

A Method for Valuing High-Risk, Long-Term Investments: ‘The Venture Capital Method’,
(Harvard Business School)

A detailed discussion of the venture capital method, including a consideration of multi-round

financing.

Share Valuation Manual, Roland Gurney, (Gower)

A collection of practical problems and traditional methods associated with valuing equity stakes
in privately-owned companies.

Practical Share Valuation, Nigel A. Eastaway and Harry Booth, (Butterworths)

A UK law and tax institutional perspective on the valuation of equity stakes in privately-owned
companies – very different from the approach in this note.

Valuing Privately-Owned Companies: 36

Valuation Techniques