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VALUING PRIVATE COMPANIES:FACTORS AND APPROACHES TO CONSIDER
PresenterVenueDate
PUBLIC VS. PRIVATE VALUATION:COMPANY-SPECIFIC DIFFERENCES
Private Firms Public Firms
Less mature Later in life cycle
Smaller size risk risk premiums
Larger and have access to public financing
Managers often have substantial ownership position
Greater external shareholder ownership
Potentially quality & depth of management
Greater quality & depth of management
PUBLIC VS. PRIVATE VALUATION:COMPANY-SPECIFIC DIFFERENCES
Private Firms Public Firms
Lower quality of information disclosure risk & valuations
pressure to make timely, detailed disclosures
Shareholders have a longer-term perspective
More emphasis on short-term performance
Greater emphasis on tax management
Less emphasis on tax management
PUBLIC VS. PRIVATE VALUATION:STOCK-SPECIFIC DIFFERENCES
Private Firms Public Firms
Shares are less liquid liquidity discount
Greater number of shareholders
Concentration of control Share ownership and control are more diffuse
Potential restrictions on sale of shares
Public market for shares
REASONS FOR PRIVATE EQUITY VALUATIONS
Transaction Related
Private financing
IPOs
Acquisitions
Bankruptcy
Compensation
Compliance Related
Financial reporting
Tax reporting
Litigation Related
Damages
Lost profits
Shareholder disputes
DEFINITIONS OF “VALUE”
• Tax reportingFair Market Value
• Real estate and tangible asset appraisalMarket Value
• Financial reporting and litigationFair Value
• Private company saleInvestment Value
• Investment analysisIntrinsic Value
PRIVATE VALUATION APPROACHES
• Based on the present value of expected future cash flows or income
Income Approach
• Based on pricing multiples from sales of similar companies
Market Approach
• Based on the value of the company’s net assets (assets minus liabilities)
Asset-Based Approach
EARNINGS NORMALIZATION
Reported Earnings
Adjustments (For
nonrecurring, noneconomic, unusual items)
Normalized Earnings
(Earnings capacity of the business if it is run efficiently)
EXAMPLE: EARNINGS NORMALIZATIONExample Adjustment to Income Statement
Private firm CEO is paid $1,200,000. Analyst estimates market rate for CEO is $800,000.
Reduce SG&A expenses by $400,000.
Firm leases a warehouse for $200,000/year from a family member. Analyst estimates market rate is $300,000.
Increase SG&A expenses by $100,000.
Firm owns a vacant building that has reported expenses of $90,000 and depreciation expenses of $15,000. The building is noncore.
Reduce SG&A expenses by $90,000. Reduce depreciation expenses by $15,000.
Firm may be acquired by a strategic Buyer A that expects synergies with cost savings of $230,000. Buyer B is a financial buyer.
Reduce SG&A expenses by $230,000 when calculating normalized earnings for Buyer A, but not for Buyer B.
CASH FLOW ESTIMATION
• 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 the Firm (FCFF)
• Start with FCFF• Subtract after tax interest expense• Add net new borrowing
Free Cash Flow to Equity (FCFE)
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 = Value of the firm• FCFF1 = Free cash flow for next 12 months• WACC = Weighted average cost of capital• gf = Sustainable growth rate of FCFF
Vf = FCFF1/(WACC – gf)
• r = Required return on equity• g = Sustainable growth rate of FCFE
Ve = FCFE1/(r – gf)
EXCESS EARNINGS METHOD
• Residual income =
- Normalized earnings – (Return on working capital) – (Return on fixed assets)
• Value of intangible assets =
• Value of the firm =
- Working capital + Fixed assets + Intangible assets
RI (1 )
g
r g
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
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
CAPM
Rf
Βi(equity risk premium)
Expanded CAPM
Rf
Βi(equity risk premium)
Small stock premium
Company-specific risk
Build-Up Approach
Rf
Equity risk premium
Small stock premium
Company-specific risk
Industry risk premium
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
EXAMPLE: REQUIRED RETURN MODELS
CAPM
1.00%
1.50(6%)
= 10.00%
Expanded CAPM
1.00%
1.50(6%)
4.00%
1.50%
= 15.50%
Build-Up Approach 1.00%
6.00%
4.00%
1.50%
1.20%
=13.70%
MARKET APPROACH: THREE METHODS
• Based on the observed multiples of comparable companies
Guideline Public Company
• Based on pricing multiples from the sale of entire companies
Guideline Transactions
• Based on actual transactions in the stock of the private company
Prior Transaction Method
GUIDELINE PUBLIC COMPANY METHOD
Identify group of comparable public companies
Derive pricing multiples for the guideline companies
Adjust pricing multiples for relative risk and growth 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
• Synergies• Contingent consideration• Noncash consideration• Availability of transactions• Changes between transaction and
valuation dates
Factors to consider in assessing pricing multiples:
PRIOR TRANSACTION METHOD
• 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
Underlying Principle
• Provides the most meaningful evidence of value since it based on actual transactions in the company’s stock
Advantages
• It can be a less reliable method if transactions are infrequent
Disadvantages
EXAMPLE: GUIDELINE PUBLIC COMPANY METHOD
Market value of debt $6,800,000.00
Normalized EBITDA $28,000,000.00
Average MVIC/EBITDA multiple 9.00
Control premium from past transactions 20.00 %
Discount for increased risk 18.00 %
EXAMPLE: GUIDELINE PUBLIC COMPANY METHOD
Public price multiple will be deflated by 18 percent
• Due to increased risk of private firm
If buyer is strategic
• A control premium of 20 percent from previous transactions is applied
If buyer is nonstrategic
• No control premium is applied
EXAMPLE: GUIDELINE PUBLIC COMPANY METHODSTRATEGIC BUYER
Risk adjustment: 9.0 × (1 – 0.18) = 7.4
Control premium: 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 METHODFINANCIAL 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
• The value of ownership is equivalent to the fair value of its assets less the fair value of its liabilities
Underlying Principle
• Difficulty in valuing• intangible assets• special purpose tangible assets• individual assets
Rarely Used for Going Concerns
• 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
Most Appropriate for
VALUATION DISCOUNTS/PREMIUMS
• Amount or percentage deduction from the value of an equity interest
Discounts
• Reflects the absence of some or all control• DLOC = 1 – [1/(1 + Control premium)]
Lack of Control Discount (DLOC)
• Reflects the absence of marketability• Applied when valuing a noncontrolling interest
Lack of Marketability Discount (DLOM)
DLOC EXAMPLE
Given a control premium of 19 percent
1DLOC 1 16.0%
1 0.19
VALUATION DISCOUNTS
Estimated Value of Equity Interest
Pro rata value of equity interest
Lack of control discount
Lack of marketability discount
Estimated Value of Equity Interest
Pro rata value of equity interest
x (1 – Control discount)
x (1 – Marketability discount)
VALUATION DISCOUNTS
Given a DLOC of 20 percent & DLOM of 16 percent
Total discount 1 [(1 0.20)(1 0.16)] 32.8%
Total discount 1 [(1 DLOC)(1 DLOM)]
VALUATION STANDARDS
• To protect third party users by promoting and maintaining a high level of trust in the appraisal and valuation practice
Objective
• To provide generally accepted and recognized standards for appraisals and valuations
• To establish requirements for impartiality, independence, objectivity, and competent performance
Function
• Focus on business valuation, real estate, and tangible assets• Adopted by 53 countries
International Valuation Standards (IVS)
SUMMARY
• Company specific• Stock specific
Differences between Private and Public Companies
• Transactions• Compliance (financial or tax reporting)• Litigation
Reasons for Private Company Valuations
• Fair market value• Market value• Fair value for financial reporting or in a litigation context• Investment value• Intrinsic value
Definitions of Value
SUMMARY
• 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
Valuation Method
• Lack of control• Lack of marketability
Discounts
• Cover the development and reporting of valuations• Protect users and the public
Valuation Standards