Valuation is a process used to determine what a business is worth. Determining a private companys worth and knowing what drives its value is a prerequisite for deciding on the appropriate price to pay or receive in an acquisition, merger transaction, corporate restructuring, sale of securities, and other taxable events. Private companies may include small family-owned enterprises, divisions/subsidiaries of larger private companies, or large corporations.

Many of the same techniques used to value public companies can be used to value private companies as well. Nevertheless, finding the true intrinsic value of a private company is a tricky task. It entails a set of calculations and assumptions based on industry-wide and company specific statistics. It includes key planning, adjusting of financial statements and applying the appropriate business valuation methodology. Unfortunately, there are several factors that influence the valuation, which include size, lack of operational history, management and operational control, difficulty quantifying earnings and cash flow, capital structure, and risk in the business.

Of the numerous acceptable valuation methods, each will yield a different result based on the sensitivity of inputs. In addition, there are certain modifications necessary to adjust for the private status of the private company. The cost of capital for private companies is different since they do not have access to capital via equity markets. The key to establishing a starting point for any private company valuation is to determine the type of the company involved, whether it is a private or a publicly traded company, and its appropriate industry.

Private Company Valuation Techniques

Though often smaller in size and less financially transparent than their publicly traded peers, private companies have a major importance in the world’s economy. Among the +150,000 firms operating in United States that generate greater than $10 million in annual revenues, roughly 90% are privately-held companies. A privately-held company is owned either by non-governmental organizations or by less than 500 shareholders so as not to require reporting with the Securities and Exchanges Commission. The private companys owners do not publicly issue or trade shares of the private company, instead they keep ownership and associated transactions discreet.

Valuation of such closely-held private companies can be expensive and difficult due to a lack of exact financial information. Although it may be difficult to research private companies, it is not impossible. There are methodologies and financial tools available to assist in making reasonable estimates of a private companys value. With an estimated value and a good intuition, one can arrive at a reasonable range of a private companys intrinsic value.

Factors Influencing Private Company Valuation

Private company valuation is not an entirely objective matter. Subjective estimates, influenced by motivations and incentives, may alter valuation outcomes. One might need to value a private company for the following reasons:

• To sell it
• To raise capital from investors
• As part of a divorce settlement
• For a management buyout
• For estate planning
• For an employee stock ownership plan (ESOP)
• For taxation purposes

Other factors that may influence a private companys valuation are its size, operating history, management and operational control, quantification of earnings and cash flow, capital structure, business risk, and breadth of liquidity in the market for private companys stock.

• Lack of Market Liquidity The lack of liquidity discounts the value of a private company by as much as 50% since there is no benchmark for valuing private companies on a daily basis as with a publicly traded exchange. Most commonly, a liquidity discount of 20-30% is applied. There are many factors that go into determining the discount factor in a private valuation including size, operating history, quality of earnings/cash flows, management, industry profile, and business risks.

Size Privately-held companies are generally much smaller than their publicly-traded comparables. Small private companies may be good acquisition targets for larger competitors and publicly-traded counterparts.

Size contributes to the discount of the valuation since it reflects the industry. Small industries may not be as attractive or may have undesirable growth rates, which could negatively influence the valuation multiple. Smaller-sized businesses also have considerably more risk than larger ones.

Valuation of Private vs. Public Companies

Private company valuations are discounted based on several risk factors associated with private sector investing, which results in a marked difference between the valuation of a privately held company, subsidiary or a division and a publicly traded corporation. There are number of distinctions between private and public companies that have an impact on the private companys value. An accurate valuation of privately owned companies largely depends on availability and reliability of the private company’s historic financial information. Public company financial statements are officially audited, documented and overseen by a government regulator. Alternatively, private firms do not have government oversight unless operating in a regulated industry and usually audited financial statements are not required.

Moreover, private companies may manage their operations for different purposes than profit. Managers of private firms often prepare their financial statements to minimize profits and, therefore, taxes. Alternatively, managers of public firms tend to want higher profits to increase their stock price. As a result, a firm’s historic financial information may not be accurate and can lead to over- and undervaluation. In an acquisition, a buyer often performs due diligence to verify the seller’s information. When analysts put a value on a particular private company, privately held companies are often valued lower than their public counterparts. The lower value is attributed to the fact that there is no liquid market for the private companys stock. Such discounts are accounted for during valuation.

Private Company Valuation Methodologies

Since private companies may manage their balance sheets and earnings for alternative purposes, discounted cash flow analysis or comparable valuation techniques require additional research. Earnings and capital structure might need to be reorganized or modified accordingly. When it comes to private companies, some nontraditional valuation techniques may be appropriate such as analysis of invested capital, replacement cost, asset appraisal and capitalization of earnings.

As discussed earlier, there are several methods for estimating the value of a particular private company. When it comes to private companies, the following three techniques are most commonly used:

1. Comparable Company Trading Multiple Analysis (also known as peer group analysis, equity comps, trading comps, and public comps)
2. Precedent/Comparable Transaction Analysis (also known as transaction comps and deal comps)
3. Discounted Cash Flow (DCF) Analysis

Other Valuation Methodologies Include:

1. Break-up Analysis
2. Asset Valuation
3. Analysis of Invested Capital/Replacement Cost
4. Leveraged Buyout (LBO) Analysis

Comparable Private Company Trading Multiple Analysis (Public Comps)

Comparable company trading multiples analysis or trading comps uses the valuation multiples of similar or comparable publicly-traded companies to value a target private company. Peers can be grouped based on any number of criteria, such as industry focus, private company size, or growth. The multiples can be Enterprise Value (EV) based multiples like EV/Sales, EV/EBITDA or EV/EBIT, and Equity based multiples like Price to Earnings (P/E). The multiples derived from this type of analysis are at a given point in time and generally change over time. It is important to note that trading multiples do not reflect control premiums or potential synergies. Generally, the following steps are applied to compare your target private company to a similar public company:

Compile and select the list of comparable companies

To select the comparable universe or peer group for a given private company target, one must understand the target private companys business to ensure that its peers share similar industry, business, and financial characteristics with the target. Among the few suitable sources that can provide insight in identifying accurate public comparables are annual reports or 10-K (especially the section on competition), the public companies prospectus, SIC code lookup, and PrivCos private company reports.

Once you have identified the comparable universe, the next step is to gather all necessary information for each peer company, usually from 10-K, 10-Q, and/or 8-K earnings press release, consensus financial projections or a recent analyst research report with financial projections.

Calculate relevant financials and multiples

Making pro forma adjustments to a comparable companys financial statements is often the trickiest part. It requires normalizing the financials to adjust for one-time / non-recurring items that temporarily distort earnings. Income statement items (denominator) should be adjusted for one-time or non-recurring items. For the valuation purposes, non-recurring items should not be included in financials (e.g. P&L statements, EBIT, EBITDA, Net income, etc).

After selecting a universe of comparable companies, create a list of ratios and values you want to compare. These can include price, shares outstanding or market capitalization, earnings per share (EPS), growth rate (five-year), price-to-earnings ratio (P/E), price-to-sales ratio (P/S), EV (enterprise value), EBITDA (earnings before interest taxes, depreciation and amortization), etc.

Next step is to calculate multiples. Multiples are the heart of the comparable companies analysis as it is hinged on both the comparable companys risk profile and operating performance. Multiples that are used should be relative to the industry and appropriate in relating the public and private companies.

Equity Multiples Certain flows apply to equity holders only, like net income and book value of equity. The balance sheet and income statement values utilized are after discretionary debt payments. Hence, equity multiples are used to derive an implied equity value. Relevant multiples:

• Price/Earnings (market equity value / net income to common shareholders)
• Price/Book (market equity value / book value of equity)
• Price/Cash Flow (market equity value / after-tax cash flow)
• PEG Ratiomeasures growth prospects (PE Ratio / Annual EPS Growth)

Enterprise multiples Other flows apply to all capital providers (debt & equity). The balance sheet and income statement values utilized are before the effects of discretionary debt payments. Hence, enterprise multiples are used to derive an implied enterprise value. Relevant multiples:

• Enterprise value/Sales
• Enterprise value/EBITDA
• Enterprise value/EBIT

It is best to compare several multiples during the analysis to determine which one(s) the market uses to value the universe of comparable private companies.

Apply valuation and analyze the results

Finally after calculating relevant multiples, one must determine implied valuation ranges. To compare comparable private companies effectively, one must understand why their multiples are different. Reasons why one private company’s projected EV/EBITDA multiple might be lower than that of a peer could include slower projected growth, declining margins, or a higher risk profile. For example, performing a comparable company analysis is an art, not a science. Its important to pay careful attention to the selection of comps, how one spreads the financial for each private company, and selection of favorable multiples.

Apply a private company discount, if applicable

It is not merely enough to simply use the same multiple as that of another publicly traded company. In most, if not all cases, the multiples that the comps universe is trading at must be subjectively adjusted as public companies will typically receive higher valuations than their privately held peers due to a lack of liquidity and the potential restructuring or accounting reorganization challenges that may arise in the event of an exit. Valuation discounts for liquidity should be applied to the private company that best reflects the target private companys risk and often ranges from 20-30%.

A major disadvantage of this valuation method is that it is often difficult to determine the right comparable private companies. Very rarely does one find two identical private companies. Hence, adjustments should be made to reflect differences, such as business mix, geographic spread and capital structure.

Comparable Transaction Analysis (Deal Comps)

Comparable transactions analysis or analysis of selected acquisitions is very similar to trading comps except deal comps utilize actual transaction multiples instead of trading multiples from the universe of comparable private companies. The analysis uses multiples and premiums paid in comparable transactions to value target private companies. When using this approach to value private companies, transactions should have relevant attributes:

• Industry group
• Timing — Transactions should be recent (typically no more than five years)
• Business mix (products, markets served, distribution channels, etc.)
• Geographic location
• Size (revenues, assets, market cap)

The process of compiling deal comps is similar to assembling trading comps, but data can be more difficult to locate. Sources of information for public deals include internal firm resources, press releases, SIC/NAICS code screen, 8-Ks, Proxys and other SEC filings.

The major disadvantage of this method is the only commonly available metric is sales, and value is not always clearly tied to sales or even profit. Moreover, precedent transactions are rarely directly comparable. Every transaction has its own set of unique circumstances and not all aspects of a transaction can be captured using valuation multiples.

Discounted Cash Flow Analysis

This method uses the forecasted free cash flow of the target private company (meeting all the liabilities) discounted by the firm’s weighted average cost of capital (the average cost of all the capital used in the business, including debt and equity), plus a risk factor measured by beta. Since risks are not always easy to determine precisely, Beta uses historic data to measure the sensitivity of the private company’s cash flow, for example, through business cycles.