Private company valuation approaches

There are three major approaches to valuation:

• Income approach: This values an asset as the present discounted value of the income expected from it.
• 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.
• 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

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 a variety of operating and non-operating assets. Non-operating assets are not required for the company’s operations, like excess cash and investment balances. The value of a company is the sum of the value of operating assets and the value of non-operating assets.

Question

Which of the following is least likely a factor to consider when selecting a private company valuation approach?

1. Size.
2. Nature of operations.
3. Underlying assets.

Solution

The correct answer is C. 

The underlying assets are least likely a factor to consider when selecting a valuation approach.

A is incorrect. Size is a factor to consider when selecting a valuation approach. Small, private companies would be valued differently compared to mature public companies.

B is incorrect. The nature of operations is a factor to consider when selecting a valuation approach. Companies at their earliest stage may be best valued using an asset-based approach because it may be difficult to predict future cash flows while mature companies may be valued using the income approach.

Reading 27: Private Company Valuation

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