PRIVATE COMPANY VALUATION

Presenter
Venue
Date
 PUBLIC VS. PRIVATE VALUATION:
COMPANY-SPECIFIC DIFFERENCES
Private Firms Public Firms
Less mature Later in life cycle
Smaller size   risk   Larger and have access to
risk premiums public financing

Managers often have Greater external shareholder

substantial ownership ownership
position

Potentially  quality and Greater quality and depth of

depth of management management
 PUBLIC VS. PRIVATE VALUATION:
COMPANY-SPECIFIC DIFFERENCES

Private Firms Public Firms

Lower quality of  pressure to make timely,

information disclosure   detailed disclosures
risk and  valuations

Shareholders have a More emphasis on short-

longer-term perspective term performance

Greater emphasis on tax Less emphasis on tax

management management
 PUBLIC VS. PRIVATE VALUATION:
STOCK-SPECIFIC DIFFERENCES

Private Firms Public Firms

Shares are less liquid  Greater number of

liquidity discount shareholders

Concentration of control Share ownership and

control are more diffuse

Potential restrictions on sale Public market for shares

of shares
REASONS FOR PRIVATE EQUITY VALUATIONS

Transactio Complianc Litigation

n Related e Related Related
Private financing
Financial Damages
IPOs reporting

Acquisitions Lost profits

Bankruptcy
Tax reporting Shareholder
Compensation disputes
 DEFINITIONS OF VALUE
Fair Market • Tax reporting
Value
• Real estate and tangible asset
Market Value appraisal

Fair Value • Financial reporting and litigation

Investment • Private company sale

Value

Intrinsic Value • Investment analysis

 PRIVATE VALUATION APPROACHES

Income • Based on the present value of

Approach expected future cash flows or income

Market • Based on pricing multiples from sales

Approach of similar companies

Asset-Based • Based on the value of the company’s

Approach net assets (assets minus liabilities)
 EARNINGS NORMALIZATION

Normalized
Adjustments earnings
(for
Reported (earnings
nonrecurring,
earnings capacity of the
noneconomic,
unusual items) business if it is
run efficiently)
 EXAMPLE: EARNINGS NORMALIZATION
Example Adjustment to Income Statement
Private firm CEO is paid $1,200,000. Reduce SG&A expenses by $400,000.
Analyst estimates market rate for CEO is
$800,000.
Firm leases a warehouse for Increase SG&A expenses by $100,000.
$200,000/year from a family member.
Analyst estimates market rate is
$300,000.

Firm owns a vacant building that has Reduce SG&A expenses by $90,000.
reported expenses of $90,000 and Reduce depreciation expenses by
depreciation expenses of $15,000. The $15,000.
building is noncore.

Firm may be acquired by a strategic Reduce SG&A expenses by $230,000

Buyer A that expects synergies with cost when calculating normalized earnings for
savings of $230,000. Buyer B is a Buyer A, but not for Buyer B.
financial buyer.
 CASH FLOW ESTIMATION
Free Cash Flow to the Firm (FCFF)
• Start with normalized earnings
• Remove interest expense
• Include an estimate of income taxes on operating income
• Add back depreciation
• Subtract a provision for capital expenditures and working
capital

Free Cash Flow to Equity (FCFE)

• Start with FCFF
• Subtract after tax interest expense
• Add net new borrowing
 INCOME APPROACH: THREE METHODS
• Free Cash Flow
- Based on the present value of future estimated cash flows and terminal value
using a risk-adjusted discount rate
- PV of expected future cash flows + PV of terminal value

• Capitalized Cash Flow

- Based on a single estimate of economic benefits divided by an appropriate
capitalization rate

• Residual Income (Excess earnings)

- Based on an estimate of the value of intangible assets, working capital, and
fixed assets
 CAPITALIZED CASH FLOW METHOD

Vf = FCFF1/(WACC – gf)

• Vf = Value of the firm

• FCFF1 = Free cash flow for next 12 months
• WACC = Weighted average cost of capital
• gf = Sustainable growth rate of FCFF

Ve = FCFE1/(r – gf)
• r = Required return on equity
• g = Sustainable growth rate of FCFE
 EXCESS EARNINGS METHOD

• Residual income (RI) =

Normalized earnings – Return on working capital – Return on fixed
assets

RI  (1  g )
• Value of intangible assets = rg

• Value of the firm =

Working capital + Fixed assets + Intangible assets
EXAMPLE: EXCESS EARNINGS METHOD

Working capital $400,000

Fixed assets $1,600,000

Normalized earnings $225,000

Required return for working capital 5%

Required return for fixed assets 12%

Growth rate of residual income 3%

Discount rate for intangible assets 18%

 EXAMPLE: EXCESS EARNINGS METHOD

1. Return on working capital = 5% x $400,000 = $20,000

2. Return on fixed assets = 12% x $1,600,000 = $192,000

3. Residual income = $225,000 – $20,000 – $192,000 = $13,000

4. Value of intangible assets = ($13,000 x 1.03) / (0.18 – 0.03) =

$89,267

5. Value of firm = $400,000 + $1,600,000 + $89,267 = $2,089,267

 DISCOUNT RATE ESTIMATION ISSUES
Size Premiums
• Size effect can increase discount rate
Cost Debt
• Relative availability may be limited  increased cost of debt
• Higher operating risk  increased cost of debt
Discount Rates in an Acquisition Context
• Should be consistent with cash flows, not buyer’s cost of capital
Projection Risk
• Uncertainty associated with future cash flows
Life Cycle stage
• Classification, early stage difficulties, company-specific risk
 REQUIRED RATE OF RETURN MODELS

Build-Up
The Expande
Approac
CAPM d CAPM
h
Rf Rf Rf

Βi(equity risk premium) Βi(equity risk premium) Equity risk premium

Small stock premium Small stock premium

Company-specific risk Company-specific risk

Industry risk premium

EXAMPLE: REQUIRED RETURN MODELS

Risk-free rate 1.00 %

Equity risk premium 6.00 %

Beta 1.50

Small stock premium 4.00 %

Company-specific risk premium 1.50 %

Industry risk premium 1.20 %

 EXAMPLE: REQUIRED RETURN MODELS

Build-Up
The Expande
Approac
CAPM d CAPM
h
1.00% 1.00% 1.00%
1.50 (6%) 1.50 (6%) 6.00%
4.00% 4.00%
1.50% 1.50%
1.20%
= 10.00% = 15.50% =13.70%
 MARKET APPROACH: THREE METHODS

Guideline Public Company

• Based on the observed multiples of comparable

companies

Guideline Transactions

• Based on pricing multiples from the sale of entire

companies

Prior Transaction Method

• Based on actual transactions in the stock of the private

company
 GUIDELINE PUBLIC COMPANY METHOD

Adjust
Identify group
Derive pricing pricing
of
multiples for multiples for
comparable
the guideline relative risk
public
companies and growth
companies
prospects
 GUIDELINE TRANSACTIONS METHOD

Most relevant for valuing the controlling interest in a

private company

Transaction data based on public filings by parties to the

transaction or from certain transaction databases

Factors to consider in
assessing pricing multiples:
• Synergies
• Contingent consideration
• Noncash consideration
• Availability of transactions
• Changes between transaction and
valuation dates
 PRIOR TRANSACTION METHOD

Underlying Principle
• Based on actual transactions in the stock of the subject company
• Based on either the actual price paid or the multiples implied
from the transaction
• Most relevant when valuing the minority equity interest of a
company

Advantages
• Provides the most meaningful evidence of value since it based
on actual transactions in the company’s stock

Disadvantages
• It can be a less reliable method if transactions are infrequent
 EXAMPLE: GUIDELINE PUBLIC COMPANY
METHOD

Market value of debt $6,800,000

Normalized EBITDA $28,000,000

Average MVIC/EBITDA multiple 9

Control premium from past transactions 20 %

Discount for increased risk 18 %

 EXAMPLE: GUIDELINE PUBLIC COMPANY
METHOD

Public price multiple will be deflated by 18%

• Because of increased risk of private firm

If buyer is strategic
• A control premium of 20% from previous transactions is
applied

If buyer is nonstrategic
• No control premium is applied
EXAMPLE: GUIDELINE PUBLIC COMPANY METHOD
STRATEGIC BUYER

Risk adjustment: 9.0 × (1 – 0.18) = 7.4

Control premium of 20% applied: 7.4 × (1 + 0.20) = 8.9

Value of firm: 8.9 × $28,000,000 = $249,200,000

Value of equity: $249,200,000 – $6,800,000 = $242,400,000

EXAMPLE: GUIDELINE PUBLIC COMPANY METHOD
FINANCIAL BUYER

Risk adjustment: 9.0 × (1 – 0.18) = 7.4

The control premium is not applied

Value of firm: 7.4 × $28,000,000 = $207,200,000

Value of equity: $207,200,000 – $6,800,000 = $200,400,000

 ASSET-BASED APPROACH
Underlying Principle
• The value of ownership is equivalent to the fair value of its assets less the fair
value of its liabilities

Rarely Used for Going Concerns

• Difficulty in valuing
• intangible assets
• special purpose tangible assets
• individual assets

Most Appropriate for

• Resource firms
• Financial services firms
• Investment companies (real estate investment trusts, closed-end investment
companies)
• Small businesses with limited intangible assets or early stage companies
 VALUATION DISCOUNTS/PREMIUMS
Discounts

• Amount or percentage deduction from the value of an equity

interest

Lack of Control Discount (DLOC)

• Reflects the absence of some or all control

• DLOC = 1 – [1/(1 + Control premium)]

Lack of Marketability Discount (DLOM)

• Reflects the absence of marketability

• Applied when valuing a noncontrolling interest
 DLOC EXAMPLE

Given a control premium of 19%

 1 
DLOC  1     16.0%
1  0.19 
 VALUATION DISCOUNTS

Estimated Value Estimated Value

of Equity of Equity
Interest Interest
Pro rata value of Pro rata value of
equity interest equity interest
Lack of control x (1 – Control
discount discount)
Lack of marketability x (1 – Marketability
discount discount)
 VALUATION DISCOUNTS

Given a DLOC of 20% & DLOM of 16%

Total discount  1  [(1  DLOC)(1  DLOM)]

Total discount  1  [(1  0.20)(1  0.16)]  32.8%

 VALUATION STANDARDS
Objective
• To protect third-party users by promoting and maintaining a
high level of trust in the appraisal and valuation practice

Function
• To provide generally accepted and recognized standards for
appraisals and valuations
• To establish requirements for impartiality, independence,
objectivity, and competent performance

International Valuation Standards (IVS)

• Focus on business valuation, real estate, and tangible assets
• Adopted by 53 countries
 SUMMARY
Differences between Private and Public Companies
• Company specific
• Stock specific

Reasons for Private Company Valuations

• Transactions
• Compliance (financial or tax reporting)
• Litigation

Definitions of Value
• Fair market value
• Market value
• Fair value for financial reporting or in a litigation context
• Investment value
• Intrinsic value
 SUMMARY

Valuation Method
• Income approach: Free cash flow, capitalized cash flow, and
residual income methods
• Market approach: Guideline public company, guideline transactions,
and prior transaction methods
• Asset-based approach

Discounts
• Lack of control
• Lack of marketability

Valuation Standards

• Cover the development and reporting of valuations

• Protect users and the public