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 StatementPrivate 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 )

gr 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 Approac

hRf

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 Approac

h 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