Valuation

The three major approaches to private company valuation are the income approach, the market approach, and the asset based approach:

1. Income approach. This values a firm as the present value of its expected future income. Such valuation may be based on various different assumptions and variations.
2. Market approach. This values a firm using multiples from recent sales of comparable assets.
3. Asset based approach. This values a firm as the value of its assets minus its liabilities.

The income approach and the asset based approach are termed absolute valuation models. By contrast, with the market approach, value is determined relative to recent valuations of other assets.

In selecting an appropriate valuation approach, an analyst should consider the firm’s life cycle stage. Early in its life, a firm’s future cash flows may be subject to so much uncertainty that an asset based approach would be most appropriate. As the firm moves to a high growth phase, it might be most appropriately valued using an income approach, in particular, a form of the income approach known as a free cash flow (FCF) valuation model.

A mature firm might be most appropriately valued using the market approach.

Firm size is also a consideration in choosing a valuation methodology. Price multiples from large public firms should not be used to value a small private firm without some assurance that the risk and the growth prospects of the firms are similar.

A firm’s assets typically consist of both operating and nonoperating assets. Nonoperating assets, those not crucial to the firm’s primary operations and focus, are typified by excess cash and investment accounts. A valuation based on income or earnings multiples would not attach a value to these nonoperating assets.

If these assets represent a significant portion of firm value, they should be separately added when valuing a firm.

Income Approaches

The income approach refers to valuation methods based on the idea that the value of an asset is the present value of its future income. Three methods consistent with the income approach are (1) the FCF method (a.k.a. the discounted cash flow method), (2) the capitalized cash flow method, and (3) the residual income (or excess earnings) method.

The Free Cash Flow Method

Under this method of private company valuation, a series of discrete cash flows are forecast, plus a terminal value that reflects the value of the business as a going concern at some future date. The terminal year represents the point of time in the future at which growth is expected to level off and remain constant. In practice, most analysts estimate the terminal value five years out.

Once free cash flows have been estimated, they are discounted at a rate appropriate to their risk.

The terminal value can be calculated using a constant growth model (e.g., the dividend discount model). Some analysts use a price multiple approach to estimate a firm’s terminal value. Note, however, that if the price multiple is for a firm in a high growth industry, the price multiple applied will often reflect both high growth and normal growth.

In this case, the high growth is double counted, once in the price multiple and once in the periodic cash flow forecasts.

Terminal value can also be calculated using the capitalized cash flow method (discussed next).

The Capitalized Cash Flow Method

The capitalized cash flow method is also known as the capitalized income method and the capitalization of earnings method. Under this method, a single measure of economic benefit is divided by a capitalization rate, equal to the required rate of return minus a growth rate, to arrive at firm value. This is a growing perpetuity model that assumes stable growth and is, in effect, a single stage FCF model.

The capitalized cash flow method is most often used for small private companies. It may be suitable when no comparables are available, projections are uncertain, and stable growth is a reasonable assumption. If growth is nonconstant, the FCF method should be used instead.

Valuing the firm as a whole using the CCM is as follows:

This CCM formula could also be used in reverse, to back out the discount rate or growth rate implicit in market data.

After tax EBIT adjusted for reinvestment in fixed and working capital is often used as a proxy for FCFF.

The reinvestment rate (or retention rate) can be calculated as follows:

And then we can calculate firm value:

To estimate the value of the equity, the market value of the firm’s debt is subtracted from firm value. Alternatively, the value of firm equity can be estimated using the following growing perpetuity formula:

The denominator in the FCFE equation is the capitalization rate of the CCM.

The Excess Earnings Method

Under the excess earnings method (EEM), the analyst starts with the earnings that should be generated by working capital and fixed assets, based on an estimate of the required return. Excess earnings are firm earnings minus the earnings required to provide the required rate of return on working capital and fixed assets. The value of intangible assets can be estimated as the present value of the (growing) stream of excess earnings (using the excess earnings and the growing perpetuity formula from the CCM).

This value for the intangible assets is added to the values of working capital and fixed assets to arrive at firm value.

The excess earnings method is employed only infrequently, but it can be useful for small firms when their intangible assets are significant. However, the required return for working capital and fixed assets is subject to estimation error.

Market Approaches

Market approaches to valuing private firms use price multiples and data from previous public and private transactions. The three methods discussed here are the guideline public company method, the guideline transactions method, and the prior transaction method.

Many practitioners prefer market approaches to valuation over income and asset approaches because actual sales data is used. Although U.S. tax courts accept both market and income approaches, they usually prefer market approaches.

As discussed previously, private firms may have risks not common to public firms, such as greater company risk and illiquidity. Therefore, it is important that the public comparables be chosen carefully. Further, price multiples reflect both risk and growth.

Each of these should be extracted from the price multiple and compared to the subject private firm separately to determine which adjustments might be appropriate. When choosing the comparables, commonalities in industry, operations, size, and life cycle are desirable.

Although public firms are often valued on the basis of price earnings ratios, large private firm valuation is usually based on enterprise value multiples such as EV/sales or EV/EBITDA.

In the following discussion, we will see that an advantage of these methods is that the comparable data are usually available. The disadvantage, however, is that the comparable transactions may not be similar to the subject transaction. Issues of comparability are discussed for each of these methods in the following sections.

Guideline Public Company Method

The guideline public company method (GPCM) uses enterprise value multiples for public companies, with adjustments to the multiples to account for differences in size, leverage, and life cycle stage between the subject firm and the comparables. Although there are usually numerous public company transactions available, the data should be scrutinized to ensure that the transactions are comparable.

When evaluating a controlling equity interest in a private firm, the control premium (i.e., the value of control) should be estimated. The control premium equals the difference between the pro rata value of a controlling interest and the pro rata value of a noncontrolling interest. Most public share trades are for small, noncontrolling interests; therefore, the price multiple does not reflect a control premium.

To estimate a control premium, a public transaction should be used where a firm was acquired, and the following issues should be considered:

• Transaction type. Recall that a transaction may be either strategic or financial. A strategic buyer is one who will have synergies with the target, while a financial buyer is one who is buying the firm for its stand alone value.
• A financial transaction typically has a smaller price premium.
• Industry conditions. Periodically, there is a flurry of industry acquisition activity, driving up acquisition prices. In such markets, share prices of public companies may already reflect some premium for control, so adding a standard control premium to such share prices may overstate the appropriate premium for control.
• Type of consideration. Some historical acquisitions will have used the acquirer’s stock rather than cash. Estimates of the control premium will be overstated when acquisitions are made with shares trading at inflated (“bubble”) values.
• Reasonableness. The use of control premiums and price multiples can sometimes compound into significant deviations from historical pricing. For example, suppose a 20% historical control premium is estimated on top of a 6x price multiple for public comparables (i.e., a multiple of 6 × 1.2 = 7.2).
• Later on, if the price multiple from public comparables at the valuation date is 10, a price multiple of 10 × 1.2 = 12 would then be applied to the private firm. The price multiple of 12 is substantially different from the 7.2 estimated earlier; thus, the 12 multiple should be investigated for reasonableness.
• Multiple industries. When using a comparables based approach, a private company operating in multiple industries should be assigned a weighted average multiple based on the proportion of revenues generated in each industry:

weighted average EV multiple = ∑$W_i$ multiple

where:

i = industry and $W_i$ = weight of Industry i in revenues of the subject company

• Other factors. Additional considerations include differences in size, country, tax status, and leverage.

Guideline Transactions Method

When using the guideline transactions method (GTM), prior acquisition values for entire companies are used. These acquisition values already reflect any control premiums, so no additional adjustment for a controlling interest is necessary (as would be the case with GPCM).

Although data about the sale of public companies is readily available, availability of information about the sale of private firms is more limited (and not always accurate). When using multiples from historical transactions, several issues should be considered:

• Transaction type. As mentioned previously for the GPCM, a prior transaction may be a strategic transaction where firm value was based, in part, on perceived synergies. If the subject transaction is nonstrategic, the analyst may need to adjust the historical multiple.
• Contingent consideration. Contingent consideration refers to that part of the acquisition price that is contingent on the achievement of specific company performance targets, such as receiving FDA approval for a drug. As contingent consideration increases the risk to the seller, transactions with contingent consideration should be scrutinized before they are compared to transactions without such contingencies.
• Type of consideration. As noted previously, some acquisitions are made with stock rather than cash. Comparing transactions of different consideration types may not be relevant.

Formula Reference

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