Private company valuation approaches

There are three major approaches to valuation:

1. Income approach:

   This values an asset as the present discounted value of its expected income.

2. Market approach:

   This values an asset based on pricing multiples from sales of assets viewed as similar to the subject asset. The multiples may be based on the share price or a measure of total company value.

3. Asset-based approach:

   This values a private company based on the values of the underlying assets of the entity less the value of any related liabilities. Asset-based and discount cash flow models are classified as absolute valuation models, while the market-based approach is a relative valuation model.

Analysts select the approach depending on the following factors:

• Nature of Operations and Stage in the Lifecycle

  At the earliest stages of development, a company may best be valued using an asset-based approach because the going-concern premise of value may be uncertain, and future cash flows may be difficult to predict. During the growth stage, a company may be valued using the income approach, similar to the free cash flow method. A stable, mature company may be valued using the market approach.

• Size of the company

  Multiples from public companies may not be appropriate for small, private companies with very limited growth prospects. Comparisons to public companies are not a good valuation basis for a private company if risk and growth prospects differ materially.

  Public and private companies may consist of various operating and non-operating assets. Non-operating assets, like excess cash and investment balance, like excess cash and investment balances, are not required for the company's operations. The value of a company is the sum of the value of operating and non-operating assets.

Income Approach

There are three forms of income approach:

Free Cash Flow Method (Discounted Cash Flow Method)

This method values an asset based on estimates of future cash flows for several years until cash flows are expected to stabilize. A terminal value is discounted by a discount rate that reflects the risks associated with these cash flows.

Terminal value estimation involves capitalizing the final estimated cash flow using a sustainable long-term growth rate or pricing multiples that should also assume sustainable cash flows.

Formula:

$$ \begin{align*} \text{Value of the firm} & = \text{Present value of expected future cash flows} \\ & + \text{Present value of terminal value} \end{align*} $$

Example: Estimating the Value of a Firm Based on the FCF Approach

The following information relates to ABC Ltd.

$$\small{\begin{array}{l|c}\text{Net profit margin} & \text{15%} \\ \hline\text{Sales in Year 0} & \$8\text{m} \\ \hline\text{Fixed capital investment in Year 0} & \$3\text{m} \\ \hline \text{Depreciation in Year 0}& \$4\text{m} \\ \hline\text{Working capital investment as a percentage of sales} & 5.5\% \\ \hline\text{Tax rate }& 30\% \\ \hline \text{Interest expense on the par value of debt of \$5m in Year 0} & 10\% \\ \hline\text{WACC during the high growth phase} & 15\% \\ \hline\text{WACC during the mature phase} & 12\% \\ \hline\text{Growth rate for the next two years} & 8\% \\ \hline\text{Long-term constant growth rate} & 3\% \end{array}}$$

Determine the value of the firm.

Solution

$$\small{\begin{array}{l|c|c|c}\textbf{Year} & \textbf{0} & \textbf{1} & \textbf{2} \\ \hline\text{Sales} & 8.00 & 8.64 & 9.33 \\ \hline \text{Net income} & 1.20 & 1.30 & 1.40 \\ \hline \text{Add Depreciation} & 4.00 & 4.32 & 4.67 \\ \hline \text{Add After-tax interest expense} & 0.35 & 0.38 & 0.41 \\ \hline\text{Less Fixed capital investment} & 3 & 3.24 & 3.50 \\ \hline \text{Less Working capital investment} & 0.44 & 0.48 & 0.51 \\ \hline\textbf{FCFF} & \bf{2.11} & \bf{2.28} & \bf{2.46} \end{array}}$$

terminal value at the end of year 2 (end of stage 1)

Then using the constant growth model, 

$$\begin{align*}\text{Terminal value}_{\text{T}} &= \text{FCFF}_{\text{T}}\times\frac{(1+\text{g})}{(\text{WACC}-\text{g})}\\ \text{Terminal value}_5&=2.46×\frac{1.03}{(0.12-0.03)}\\&=$28.15\\ \\ \text{Value of the firm}&=\frac{2.28}{1.15}+\frac{(2.46+28.15)}{1.15^2} \\&=$25.13\end{align*}$$

Capitalized Cash Flow Method

This method estimates the value of a private company based on the value of a growing perpetuity. This is similar to the single-stage free cash flow model. This is appropriate for private companies with no projections and an expectation of stable future operations. The free cash flow method is more appropriate for companies whose growth rate is expected to change significantly.

The formula for the capitalized cash flow is:

$$\text{V}_{\text{f}}=\frac{\text{FCFF}_1}{(\text{WACC}-\text{g}_{\text{f}})}$$

Where:

\(\text{V}_{\text{f}}=\) value of the firm.

\(\text{FCFF}_{1}= \) Free cash flow to the firm for the next twelve months.

\(\text{WACC}=\) Weighted average cost of capital.

\(\text{g}_{\text{f}}=\) Sustainable growth rate of FCFF .

The denominator of the above equation, \((\text{WACC}-\text{g}_{\text{f}})\), is known as the capitalization rate. 

The value of equity can be computed by deducting the market value of debt.

$$\text{V}_{\text{e}}=\text{V}_{\text{f}}-\text{Market Value of debt}$$

The capitalized cash flow method can also be used to value equity directly.

$$\text{V}_{\text{e}}=\frac{\text{FCFE}_{1}}{(\text{r}-\text{g})}$$

Where:

\(\text{r} =\) Required return on equity.

 \(\text{g}=\) Sustainable growth rate of FCFE.

Example: Calculating the Value of the Firm based on the Capitalized Cash Flow Model

Suppose a company's free cash flow to the firm was $ 30 million in the previous period and is expected to grow by 3.5% annually. The WACC is estimated to be 12%. Given the market value of its debt is 60million, the value of the firm and equity can be calculated as:

Solution

$$\begin{align*}\text{Value of the firm}&=\frac{\text{FCFE}_{1}}{(\text{WACC}-\text{g})}\\ &=\frac{30(1.035)}{0.12-0.035}\\&=365.29\ \text{million}\\ \\\text{Value of equity}&=365.29 \text{m}-{60 \text m}\\&={305.29 \text m}\end{align*}$$

Residual Income (Excess Earnings) Method

This method estimates the value of all the intangible assets of the business by capitalizing future earnings in excess of the estimated return requirements associated with working capital and fixed assets.

$$ \begin{align*} \text{Residual income (RI)} & = \text{Normalized earnings} – \text{Return on working capital} \\ & – \text{Return on fixed assets} \end{align*} $$

And

Value of intangible assets: \(\text{V}_{\text{intangible}}=\frac{\text{RI}_{0}(1+\text{g})}{(\text{r}_{\text{intangible}}-\text{g})}\)

Value of the firm: \(\text{V}_{\text{firm}}=\text{V}_{\text{intangible}}+\text{Working capital}+\text{Fixed assets}\)

Example: Estimating Firm Value Based on the Excess Earnings Method

Consider the following information:

$$\small{\begin{array}{l|r}\text{Working capital }& 45,000 \\ \hline \text{Fixed assets} & 180,000 \\ \hline\text{Normalized earnings (year just ended)} & 21,150 \\ \hline \text{The required return for working capital} & 3\% \\ \hline \text{The required return for fixed assets} & 8\% \\ \hline \text{The growth rate of residual income} & 2.5\% \\ \hline \text{Discount rate for intangible assets} & 18\% \end{array}}$$

The value of the firm is closest to: 

Solution

$$\begin{align*}\text{Return on working capital}&= 3\% \times$45,000\\&= $1,350\\ \\ \text{Return on fixed assets}&= 8\% \times$180,000 \\&= $14,400\\ \\ \text{Residual Income}&= $21,150－ $1,350 －$14,400\\&= $5,400\end{align*}$$

Value of intangible assets: $$\begin{align*}\text{V}_{\text{intangible}}&=\frac{\text{RI}_{0}(1+\text{g})}{(\text{r}_{\text{intangible}}-\text{g})}\\ \\ \text{Value of intangible assets}&=\frac{$5400\times1.025}{0.18-0.025}\\&=$35,710\end{align*}$$

Value of the firm: $$\begin{align*}\text{V}_{\text{firm}}&=\text{V}_{\text{intangible}}+\text{Working capital}+\text{Fixed assets}\\&=$35,710+$45,000+$180,000 \\&= $260,710
\end{align*}$$

Market Based Approach

The market approach uses direct comparisons to public companies to estimate the fair value of an equity interest in a private company. The three major variations of this are:

1. The guideline public company method (GPMC).
2. The guideline transactions method (GTM).
3. The prior transaction method (PTM).

The market approach is preferred over the income and asset approach because it uses actual market transactions.

Factors for identifying guideline companies are similar for public and private companies. Key factors include industry membership, operations form, trends, and current operating status.

Public and private company analysis may differ in the financial metrics used in the valuation process. Price-to-earnings ratios are frequently used in the valuation of public companies, while EBITDA/EBIT multiples are used in the valuation of larger mature private companies. EBITDA is best compared to the market value of invested capital (MVIC), which is the market value of debt and equity. Net income multiples are commonly used for smaller private companies, while revenue multiples are used for small private companies.

Guideline Public Company Method

The value of a private company is based on the observed multiples from the trading activity of comparable public companies’ shares. These multiples are adjusted for differences in risk and growth of the private company.

The primary advantage is the large pool of guideline companies and available information. Disadvantages include possible issues regarding comparability and subjectivity in the risk and growth adjustments to the pricing multiple.

Control premiums are used in the valuation of controlling interests. A control premium is an amount or a percentage by which the pro-rata value of a controlling interest exceeds the pro-rata value of a noncontrolling interest in a company. A control premium is added to the controlling interest value computed using GPCM.

Factors to Consider in Assessing Pricing Multiples

• Type of Transaction. Transactions could either be financial or strategic. A strategic transaction involves an acquirer who would benefit from synergies by acquiring the target company. A financial transaction involves an acquirer who expects no synergies from acquiring the target. Control premiums are higher for strategic transactions compared to financial transactions.

• Industry Factors. It is assumed that industries that are experiencing acquisition already reflect a control premium in their prices because of the probability of acquisition.

• Form of Consideration. A stock exchange transaction might not be appropriate when measuring control premiums because management typically prefers to use stock in acquisitions when they believe their shares are overvalued.

Example: Value of the Private Company using Pricing Multiples

The following information has been gathered regarding comparable public companies to a private company that is being valued:

MVIC/EBITDA of comparable public companies is 5.

A downward adjustment of 15% to the average public company MVIC/EBITDA is required to reflect the risk and growth of the private company.

The private company's normalized EBITDA is $ 12 million, and the market value of debt = $ 7 million.

The value of the private company and its equity can be calculated as:

$$\begin{align*}\text{Adjusted MVIC/ EBITDA}&=5\times(1-0.15)\\&=4.25\\ \\ \text{Value of firm}&=4.25\times\text{12m}\\&=\text{51m}\\ \\ \text{Value of equity}&=\text{51m}-\text{7m}\\&=\text{44m}\end{align*}$$

Guideline Transactions Method (GTM)

The value is based on pricing multiples derived from the acquisition of comparable public or private companies. GTM uses a multiple related to the sale of entire companies. Transaction data is compiled from public filings. Transaction multiples are most appropriate for valuing a controlling interest in a private company.

Factors to Consider when using transaction-based pricing multiples include:

• Synergies: The price of comparable strategic acquisitions may include adjustments for anticipated synergies.

• Contingent considerations: Potential future payments to the seller are contingent on meeting certain milestones like achieving a target EBITDA. Including contingent considerations in acquisition agreements reflects uncertainty about future financial performance.

• Noncash consideration: Acquisitions may include stock in the consideration. The cash equivalent value of a large block of stock may create uncertainty regarding the transaction price.

• Availability of transactions: Meaningful transactions for a specific private company may be limited.

• Changes between the transaction date and valuation date: The period between the transaction date of the comparable transaction and the valuation date should also be considered as numerous changes may have occurred during the two dates.

Example: Guideline Transactions Method

The following information has been gathered regarding transactions involving comparable public companies to a private company that is being valued:

The MVIC/EBITDA multiples from recent private company acquisitions in the industry are 7.

The acquired companies' overall risk and growth opportunities are similar to those of private company.

If the private company's EBITDA is $13 million and the market value of its debt is $13 million, the value of the firm and its equity can be calculated as:

$$\begin{align*}\text{Value of the firm}&=7\times13\\&=\text{91m}\\\text{Value of equity}&=\text{91m}-\text{13m}\\&=\text{78m}\end{align*}$$

Prior Transaction Method

This is based on actual transactions in the stock of the subject private company. It is most relevant when determining the value of a minority interest in a company.

The advantage of this approach is that it provides the most meaningful value as it is based on actual transactions in the company's stock. On the other hand, it is a less reliable approach for infrequent transactions.

Question

For a company with the following information:

• Working capital = $23,000
• Fixed assets = $85,000
• Normalized earnings for the previous period = $90,000
• The required rate of return for working capital assets and fixed assets is 6% and 11%, respectively.
• Residual income is expected to grow at 6%, and the discount rate of intangible assets is 10%.

The value of the firm is closest to:

1. $2,208,655.
2. $2,802,655.
3. $2,028,655.

ma

Solution

The correct answer is A.

$$\begin{align*}\text{Working capital required return}&=$23,000\times0.06=$1,380\\ \text{Fixed assets required return}&=$85,000 \times 0.11=$9,350\\ \text{Residual income} &= $90,000-$1,380-$9,350 \\ & =$79,270\\ \text{Value of intangible assets}&= \frac{$79,270 \times 1.06}{0.10-0.06}\\ & =$2,100,655\\ \text{Value of the firm}&=$2,100,655+$23,000+$85,000 \\ & =$2,208,655\end{align*}$$

Reading 27: Private Company Valuation

LOS 27 (g) Explain the income, market, and asset-based approaches to private company valuation and factors relevant to the selection of each approach.